New Trade – $MSFT: Surface to Air?

by Dan March 17, 2014 2:51 pm • Commentary

I am going to do something that I have not done in Microsoft on the site in a very long time, attempt to make a bull case.  You’d be hard-pressed to come up with a short list of large cap tech companies that get less love than MSFT on both the product front and sentiment towards the stock.  I am not a fan of the company’s products, their vision (if one exists) and the future of their core businesses.  That being said,  the stock price may adequately reflect a good bit of the pervasive negtative. The company has a rock solid balance sheet with 20% of their market cap in cash, net of debt ($61 billion), strong cash generation, 2.93% dividend yield, massive multi-billion dollar share buyback, cheap valuation and new management that seems dead set on moving their business from the data center to the cloud. The fundamental debate will likely remain a battleground for some time, and I’ll leave that to analysts other than me, but the technical set up could be in stark contrast to that of the stock’s sentiment.  

Since its ten year high in December, the stock has not confirmed any sort of breakout even while the broad market made a series of new highs over the last couple months.

The 14 year chart below though may shed some light on what it would take to establish a new range after more than a decade long consolidation.  I will make one caveat though, it would take a fairly substantial re-positioning of the company and its products for investors to re-rate the stock on a valuation basis prior to any evidence of a resurgence in innovation and earnings growth.

But first the near term, the one year chart below shows the recent consolidation below the December high at about $39, while the $35/36 range should serve as very healthy support on the downside.

[caption id="attachment_37623" align="aligncenter" width="589"]MSFT 1yr chart from Bloomberg MSFT 1yr chart from Bloomberg[/caption]

On a longer term basis, the 14 year chart below shows what could be a massive Head and Shoulders bottom with the $39/$40 level the neckline.  Above $40 there is little meaningful resistance until in the high $40s.

[caption id="attachment_37624" align="aligncenter" width="589"]MSFT 14 year chart from Bloomberg MSFT 14 year chart from Bloomberg[/caption]

Lastly, on a vol basis, options are very cheap trading near multi year lows, as the 3 year chart of 30 day at the money implied vol shows below:

[caption id="attachment_37625" align="aligncenter" width="589"]MSFT 3 year chart of 30 day at money IV from Bloomberg MSFT 3 year chart of 30 day at money IV from Bloomberg[/caption]

Conclusion:  Sentiment is poor, new management has incentives to turn things around, the company is committed to returning cash to shareholders, competitors have left them for dead, the technical set up could be explosive and the options market is offering those with a contrarian view a way to play with defined risk, but leg into the view in front of their next identifiable catalyst in late April, fiscal Q3 earnings scheduled for April 24th.

Trade:  MSFT ($38.20) Bought the April / May 40 Call Calendar for .40

-Sold April 40 Call at .18

-Bought May 40 Call for .58

Break-Even on April Expiration:

-Profits are maximized at 40 on April expiration. Slight moves above and below that strike are also profitable with big moves higher or lower putting the structure at risk of losses on expiration.

-Max risk is 40 cents

Rationale: While options are cheap, I don’t expect the stock to just break out to new highs without a catalyst, I suspect upcoming earnings could be that catalyst, but owning premium in a stock that has not been moving is no way to put the odds in your favor. Therefore I prefer the calendar and will look to sell weeklies against the May calls if the stock is below $40 on April expiration in order to further finance owning the May calls for the earnings event.