Goldman Sachs Admits Mistake in Banishing Microsoft

Back in April of 2013, Goldman Sachs downgraded Microsoft to "sell" -- a rating infrequently cast upon large tech companies and a clear signal that the influential investment bank had little faith of a turnaround in Redmond. Goldman Sachs today said despite the uphill battle Microsoft faced and shared by most in the industry that it underestimated its ability to revitalize its business.

Taking a still measured approached given challenges that remain, Goldman updated Microsoft to "neutral." Certainly Goldman wasn't the only skeptic about Microsoft's prospects a few years ago. Microsoft's missteps in the mobile revolution had many critics wondering if Amazon Web Services, Apple, Google and VMware were poised to make Microsoft irrelevant. Since Satya Nadella has taken over in February 2014, followed by this year's release of Windows 10, the success of Office 365, Azure and making key acquisitions, Microsoft is a much different company, a shift Goldman Sachs acknowledged in the release its report, titled "Righting a Wrong."

Not only did it take Microsoft off of the sell list, but Goldman Sachs analysts acknowledged in hindsight that they shouldn't have put the company there in the first place. "We were wrong," read the report. "We failed to appreciate that the stock would disconnect from downward EPS revisions, and the significant upward rerating of the multiple driven by MSFT's transition to the cloud (Office 365 and Azure)."

Since downgrading Microsoft on April 11, 2013, Microsoft's stock has risen 84% compared with a 29% increase of the S&P 500. The firm set a 12-month price target for Microsoft's stock between $45 and $57 per share. At the time Goldman downgraded Microsoft, the analysts did so on the basis that Microsoft was facing declining PC sales and their view that consensus earnings projections were too high.

According to the report: "The company has been successfully transitioning its Office installed base to Office 365, is the number two leader in cloud services behind Amazon Web Services and has shown strong operating expense discipline and capital allocation."

Goldman also says it's optimistic about the Microsoft cloud transition and believes it will be a top driver of growth for the company and that the transition to Office 365 "will lead to an uplift in revenue and gross profit, and new leadership has executed well, reallocating OPEX away from slower growing areas and towards higher growth and more strategic areas of the company such as cloud."

The firm is also increasing EPS estimates in FY17 and beyond as it anticipates Azure and Office 365 offering faster gross margins. "We expect Azure can reach AWS-like margins when they reach similar revenue levels as AWS."

Goldman still believes consensus estimates for Microsoft's FY17, which kicks off July 1, 2016, are too high. Its estimates are $2.86 per share versus $3.12 and warns there's still downside risk in the coming two fiscal years.

Investors appear to have shrugged off the upgrade, with its shares trading down 1.4% in midday trading on a day where the broad market is down sharply. Despite the slight drop, Microsoft's shares are trading at approximately $55 -- which is on the higher end of Goldman's price target.

Posted by Jeffrey Schwartz on 12/18/2015 at 12:16 PM