Is Microsoft a Better Pick Than Apple? Thursday's earnings will tell.

01/28/2016 9:13 am EST

Focus: STOCKS

Michael Berger

President & Founder, Technical420.com

After the market closes Thursday this tech powerhouse will report earnings, and so Michael Berger of Technical420.com highlights a number of reasons he expects to see results exceed Wall Street expectations.

Apple (AAPL) may have over $216 billion in cash on their balance sheet, but they apparently do not know where to invest it. AAPL could use its cash to bail out Greece for a few months (even though that would not be a safe investment); Although they could use it to increase its dividend, many investors would not like that because it would make AAPL an income investment instead of a growth investment; Or they could use their cash to make the company stronger through accretive acquisitions (i.e. Twitter (TWTR), Yahoo (YHOO), Tesla (TSLA)).

While we remain favorable on the long-term outlook of AAPL, we see more value in Microsoft Corporation (MSFT) from a total return perspective. After the market closes Thursday, MSFT will report earnings and we expect to see results exceed Wall Street expectations.

Global market weakness has caused shares of MSFT to fall approximately 8% since the start of the year. This dip comes after MSFT outperformed the S&P 500 (SPX) during 2015. During the last three months of 2015, MSFT rallied almost 30%. We attribute much of this rally to the worst of the headwinds associated with the move from XP to Windows 7 being behind them. Going forward, we expect this to serve as a catalyst for the March and June quarters because of the easy comparables from the same periods during 2015.

Investment Thesis

Our investment thesis is based on both gross and operating margins reversing its declining trend. Another component of our thesis pertains to MSFT's commercial software business turning the corner and recording positive mid-single digit growth. This is a major improvement after recording negative growth last year as the headwinds from a Windows XP refresh dissipates.

After MSFT announced earnings for the September 2015 quarter, management addressed several items that improved visibility, specifically: 1) Operating income turned the corner and is headed for growth after four years of flat performance; 2) Gross profits also turned the corner as gross margins increased by 250 basis points (this reversed a year-over-year trend that lasted several years); 3) MSFT recorded quality revenue growth (not from low-margin hardware, but also software) and saw an overall improvement in gross margins. In previous quarters, hardware dominated growth and operating income had been propped up by expense control.

EPS Growth Is Fueling Share Price Breakout

From March 2014 until the rally in late 2015, MSFT had been stuck in the $40-$49 range as expectations for an earnings breakout were not met with fundamentals. We think MSFT has reached a turning point as reflected in the most recent quarter.

Our concerns related to how the cloud transition would impact gross margins were adequately addressed when MSFT reported commercial cloud gross margins (81%) that were much higher than what Wall Street expected. This feat was accomplished despite low margin Microsoft Azure revenues growing by 135% on a year-over-year basis. We believe this business is now at scale and the next milestone for the company is 25% operating margins.

Valuation Is Attractive

Not only does MSFT represent a growth opportunity for investors, but it also offers a 2.7% dividend. We see more than 15% upside to current levels and expect to see shares trading in the mid-60s by the end of 2016. When you include the dividend, investors could achieve an 18%-20% total return with MSFT during 2016.

Michael Berger, Founder and President, Technical420.com

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