$MSFT fQ2 Earnings Preview

by Dan January 24, 2013 12:31 pm • Commentary

Event: MSFT reports their fiscal Q2 earnings today after the close.  The options market is implying a 3.2%*, shy of the 4 quarter averaged of 3.7%, but essentially in line with the 8 quarter average of ~3%.  MSFT has rallied on 4 of the last 8 earnings releases with the average gain of ~3%, while the average decline was ~2.9%.  *With the stock ~$28, the Jan25th 28 straddle is offered at .90, so if you bought it you would need a move above 28.90 or below 27.10 to make money.  

Sentiment: Wall Street analysts are relatively bullish, with 29 buys, 16 holds, and no Sells, with any avg 12 month price target of ~$33.  Short interest is quite low, at 1.15% of float according to Bloomberg.

Fundamentals: Microsoft has a pristine balance sheet, as its $66 billion of cash, $54 billion net of debt.  Its main issue has been earnings growth, which saw a fairly steep decline over the past year to low single digits with expected growth of the same in fiscal 2013  Analysts still expect Windows 8 will will reinvigorate growth of ~12% in fiscal 2014 (which has come down from the high teens following the company’s lackluster early results of the OS’s Nov launch).

SO what does PC, tablet and smartphone demand look like over the last 4 months? If  AAPL’s less than stellar results last night are any indication, then it is fair to say that their miss of 1 million iMacs, 2 million iPhones and 1 million iPads would suggest that MSFT’s operating system on far less desirable hardware is likely to share a similar fate.

Valuation:  The P/E multiple is near 7 year (and all-time) lows, as the stock has lost its growth mojo, but offers an attractive 3.3% dividend.  Of course, as we saw with INTC, that 3% dividend yield can become 4% quite quickly if investors start to see the overall business as declining.  Here is the 7 year chart of the P/E:

[caption id="attachment_21919" align="aligncenter" width="490"]MSFT 7 yr PE chart from Bloomberg MSFT 7 yr PE chart from Bloomberg[/caption]


Price Action / Technicals:  After having a fairly disappointing year from a stock performance perspective (stock closed up only 4% after being up 26.5% at one point in Q1), MSFT is slightly out-performing the Nasdaq in 2013 up ~5% ytd.

The five year chart below shows that besides the year that was the financial crisis, the stock has spent the better part of this period stuck btwn $25 and $30.  Up until this past fall, after investors finally became aware that Windows8 would in fact NOT cause a meaningful PC upgrade cycle, the stock broke the uptrend line that had been in place.

[caption id="attachment_21920" align="aligncenter" width="490"]MSFT 5 yr chart from Bloomberg MSFT 5 yr chart from Bloomberg[/caption]

In the near term, barring an earnings miss or guide down of significant magnitude, I would expect $25 to serve as serious support, while $30 would be a place where the stock could pause on the upside, but if MSFT was able to demonstrate meaningful earnings growth on the heels of new products and given the stock’s very cheap valuation we could see a test of $32/$33 as the market rally broadens out.  I would be shocked to see that sort of pickup in just the last few months, so I place low odds on that happening in the near term.

Volatility:  MSFT vol across all months has stayed historically low as the stock has bounced around in a tight range since November.

[caption id="attachment_21911" align="aligncenter" width="588"]Screen Shot 2013-01-24 at 9.16.06 AM 2 year HV30 vs IV30 from LiveVol Pro[/caption]

With only 1 day until expiry, the Jan25 weekly options sit at about 62 vol, but dollar wise are only pricing in about a 90c event move. February regulars are 23 vol and should come into the high teens following the event. So not much to trade from a vol perspective, this is basically a dollar premium play at this point.

My View:  Given the recent IDC and Gartner  issued reports suggesting that Q4 PC shipments were down btwn 4.6% and 6.4% respectively year over year, and INTC’s poor Q4 results reported last week, I am hard pressed to think that MSFT is able to buck the broader trends, despite their new product cycle.  AAPL’s iOS results don’t bode well for sales of MSFT’s Surface, which I would expect to be discontinued at some point in the next year. And go pop into any AT&T or Verizon shop and ask a salesperson how many Lumina phones they have sold lately.

With the stock trading in the middle of the 3 month range, It makes the set up from a trading perspective fairly difficult.  With implied vol on the low side long premium directional could make sense if they were coupled with strong fundamental conviction.

We are evaluating a few different structures with an obvious bent towards the downside.