You don’t need an Xbox to appreciate Microsoft

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When Microsoft Corp. announced this month that it was tweaking its Windows 8 operating system in response to a poor reception following its launch in October, you could almost hear the collective one-word response from investors who have avoided Microsoft shares: typical.

But while the technology company continues to stumble with many of its new products, its share price has been dazzling this year. It has risen more than 30 per cent in 2013, to its highest level in more than five years.

The gains come as Microsoft readies consumers for its new gaming console, called Xbox One – the latest in a series of consoles that have succeeded enormously. Yet, the bullish argument for Microsoft doesn't even factor in this consumer element.

On Tuesday, UBS analyst Brent Thill raised his price target on the shares to $40 (U.S.) from $33 – a 21 per cent boost – while maintaining a "buy" recommendation. He believes there are five drivers behind the new share price target.

1. Greater earnings visibility. Mr. Thill points out that investors have questioned Microsoft's profit outlook in recent years, due to falling profit margins and exposure to a struggling computer market.

However, Microsoft is successfully moving to cloud computing: "The ability to shift toward a more recurring revenue model has received a positive reception by Wall Street with the stock doubling the performance of the Nasdaq year-to-date, which we believe will embolden MSFT to give improved financial visibility going forward," Mr. Thill said in a note.

2. Investors will appreciate cloud momentum. Cloud computing is on the rise, and Microsoft's share of the market should rise faster than other players in the market.

"Amazon.com Inc. trades for 200-times estimated 2013 earnings, we believe partly on investor excitement for the potential of Amazon Web Services," Mr. Thill said. "MSFT trading for 1/20 that valuation at 11-times estimates 2013 earnings does suggest there is room for investors to increasingly appreciate how well positioned MSFT is for the industry shift towards cloud."

3. "Core enterprise" will be better appreciated. Investors are focused on the declining health of the PC market, but ignorning Microsoft's strength in catering to businesses – where sales are growing rapidly.

"Unearned revenue has grown double digits for eight quarters now and in key enterprise segments like Server and Tools where it competes with heavyweights like ORCL, IBM and VMW, MSFT has had 11 quarters in a row of mid-to-high teens unearned revenue growth," Mr. Thill said.

4. About those PCs.... Yes, the news on the PC market has been grim. According to IDC, worldwide PC shipments fell nearly 14 per cent in the first quarter of 2013, year-over-year – the biggest contraction on record for data going back to 1994. That's not good news for a company that provides the operating system for most PCs.

But Mr. Thill believes that the worst is probably over: The Windows upgrade should help the market or at least make it "less bad." And even if sales continue to slump, "We'd argue the PC market doesn't have to grow for MSFT's stock to work," he said.

5. Get ready for a tech rally. Tech stocks tend to follow seasonal trends, with weak performance in the first half of the year as companies set their IT budgets, followed by strong demand in the second half of the year. Despite its impressive gains already, Microsoft should benefit.

"As money shifts into technology stocks we believe investors will gravitate towards MSFT given its unique profile of growth tied to both a strong product cycle as well as improving macro conditions, margins bottoming in the current fiscal year, 'rare-for-tech' 2.6 per cent dividend yield, and the opportunity to improve cash distribution as MSFT has double-digit free cash flow growth potential," Mr. Thill said.