Microsoft or Microhoo! Doesn't Matter; INITIATING Coverage with an OUTPERFORM Rating and Target Price of $35
• Initiating coverage of Microsoft with an Outperform rating and a $35 target price. We believe that the market has meaningfully undervalued not only the long-term sustainable growth but also the near-term defensive characteristics of Microsoft's dominant market positions with respect to its client operating system and office productivity suites. In our opinion, Microsoft's current stock price and valuation imply overly negative assumptions regarding the company's ability to fend off competition in its core businesses, as well as a complete destruction of shareholder value from a potential Yahoo! acquisition. • Buying Server & Tools for free. Given that we have forecasted revenue growth rates for Microsoft's Client and MBD businesses inline with those divisions' end markets, we believe that investors can essentially purchase Microsoft's Server & Tools business, as well as options on its E&D and OSB segments, "for free," based on our sum-of-the-parts analysis, which suggests a fair value for these businesses, plus corporate overhead and cash of approximately $30.00 per share. Furthermore, even assuming that Microsoft destroys $3.50-4.00 per share in shareholder value from the acquisition of Yahoo!, Microsoft's current stock price would still include no value for the aforementioned divisions. • Do you Yahoo!? We believe that Microsoft will eventually at least acquire Yahoo!'s search assets, given that acquiring Yahoo! represents the only way for Microsoft to effectively narrow the gap with Google in the Internet search market. However, while the overhang of a potential deal with Yahoo! will likely remain for the near term, our sum-of-the-parts DCF analysis frames Microsoft's valuation versus the probability of a transaction and reaffirms a mid-$30s target price. • Growing faster, but trading cheaper. Despite trading at a 15-year trough relative P/E discount to the S&P 500 of 6.5%, we forecast Microsoft's NTM EPS to grow 310 bps faster than the S&P 500, a level greater than the 5-year and 15-year average growth premiums of 150 bps and 280 bps. We view this discrepancy as a unique opportunity to invest in one of technology's bellwethers at a meaningful discount relative to expected forward growth rates.