Merill Lynch‘s Kash Rangan today cut his rating on shares of Microsoft (MSFT) from Buy to Neutral for the first time since September of 2008, and cut his price target to $33 from $35, writing that he “remained optimistic” the shares could continue to perform past the October 26th retail debut of Windows 8 last year, but that “six months post launch, despite more available touch-based devices, Win 8 lacks momentum, challenging our optimism.”
Microsoft shares today are down 7 cents at $28.48. The stock is down 10% since the October Windows debut.
Rangan cut his estimates for Microsoft for the fiscal year ending in June to $79.3 billion in revenue and $2.77 in net profit per share from a prior $79.9 billion and $2.91 per share, below the consensus $79.4 billion and $2.83 per share.
Rangan cites data from his colleagues covering computer hardware at a Merrill Lynch technology conference held recently in Taiwan that suggest a weakening PC market, down perhaps 5% in units this calendar year, worse than his prior expectation for a 3% decline, he writes.
That puts Microsoft consumer revenue at risk, he writes:
MSFT is up 8-9% in recent weeks in anticipation of Haswell/Bay Trail/Blue but it is time for a breather to re-assess the risks. We could be wrong with our downgrade if we get unit growth in Win 8-based PCs and tablets in C14. While investors are concerned about the risk to $5b revs (est 25% of Windows revs coming from consumer), resulting in ~$0.30 hit to EPS, we would get more positive once the Street stops focusing on Win and shifts focus to MBD and Server and Tools.
Moreover, Rangan sees limited prospects for a PC rebound in the back half of this year:
Virtually all suppliers/distributors agreed that notebook unit decline in C1Q13 was/is worse than anticipated and expect C2Q13 units to remain flattish Q/Q. In fact, the 2013 outlook for most points to another year of unit decline for notebooks (down ~5% Y/Y). Overall sell-through around Chinese New Year was poor, and as a result, we will likely see a greater notebook inventory adjustment in April/May, prior to Intel’s Haswell launch and inventory replenishment in June [...] We also believe that expectations of a 2H seasonal rebound are built on hope with healthy skepticism. The European economy is still contracting and is a headwind. Trends out of distribution companies in Europe (retail in Europe is higher than US) and a really competitive market in the US (margins getting hit and demand spotty) continue to be weak. In addition, price points still appear to be still too high on ultrabooks/thin-and-light and lack of touch screen product at reasonable prices is also an issue. In addition, we believe the tablet cannibalization that was maybe overstated at first (i.e. was more of a wallet decision at first due to macro) is becoming more of an issue. As more enterprises allow tablets onto their infrastructure, more are them using for work purposes [The PC supply chain hopes Haswell-based notebooks with touch functions will reignite muted Win 8 PC demand in C2H13, including some refresh in the commercial segment (Win XP at the end of support in early 2014). Most PC industry participants our Hardware team met with expect touch notebooks to represent 20-40% of total notebooks by the end of C2013 (~10-20mn quarterly run rate) vs. <10% in C1Q13 (~4mn runrate), which we believe could prove to be aggressive. The availability and pricing of touch panels remain key factors. As additional production capacity for touch panels comes online (e.g. TPK plans to expand NB capacity to 1.8mn/3mn in C3Q/4Q13 from 1.2mn today), we expect current supply constraints to be resolved and touch panel price premium to narrow closer to ~$50 in C3Q13 (vs. $70-100 today).
Reflecting on Microsoft's payouts to shareholders, and a low valuation that he puts at 10.3 times this year's projected earnings per share, Rangan concludes those desirable qualities are not enough:
The MSFT bull case was low valuation and capital return, which are not the issues. It has admirably solved for revenue, EPS, cash flow and billings, but confidence is lacking in unit growth of Win 8 consumer devices [...] It is difficult to pivot the investment case on MSFT till the fog of consumer Win 8 lifts.
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