Event: Microsoft (MSFT) reports fiscal Q2 results tonight after the close. The options market is implying about a 5.75% one day move, which is essentially in line with its 4 qtr average one day move of about 5.9%, but above the 10 year average of about 4.5%.
Price Action / Technicals: Shares of MSFT are down a little less than 7% on the year, basically in line with the S&P 500’s 7.5% decline and far better than the Nasdaq Composite’s 10.5% ytd decline. Just prior to the last day of 2015, MSFT was trading at levels not seen since the start of the collapse of the dotcom bubble in early 2000.
The one year chart is fairly instructive, as the late October breakout above $50 following their better than expected results should serve as formidable near term technical support, but below that, little support till the mid $40s:[caption id="attachment_60738" align="aligncenter" width="600"] MSFT 1 year chart from Bloomberg[/caption]
Looking at the 10 year chart on a log scale shows the very well defined uptrend from the stock’s financial crisis lows in early 2009. A retest of the uptrend would place the stock in the mid to low $40s:[caption id="attachment_60743" align="aligncenter" width="600"] MSFT 10 yr log chart from Bloomberg[/caption]
Expectations: Last quarter the stock rallied 10% after reporting better than expected results in their efforts to transition consumers and companies to Office 365, their cloud based Office offering, while their Commercial Cloud segment grew at an annualized pace of $8.2 billion, on lower costs. Cloud migration and growth is offsetting a weak PC market, which Gartner suggests was down 8% year over year in Q4, and INTC just told us that servers were weak in Q4, we know that mobile is weak from recent commentary from Apple and Samsung. And we know that enterprise spending is weak from results from IBM and VMW. So I think it is safe to say that expectations are not particularly high.
Valuation: MSFT trades almost 19x expected 2016 eps (vs 5% expected eps growth and flat sales), which is at a post financial crisis high, and well above a market multiple:[caption id="attachment_60752" align="aligncenter" width="550"] From Bloomberg[/caption]
Capital Return: With a $411 billion market cap, MSFT has 24% of its market cap in cash, 15% net of debt. The company is in the midst of a $40 billion share buyback announced in 2013, and returned over $20 billion in 2015 in the form of buybacks and dividends, with a dividend yield currently of 2.8%.
Options and Volatility – Implied vol is much higher going into this event than other earnings reports over the past two years:[caption id="attachment_60748" align="aligncenter" width="690"] 2 yr vol from LiveVol Pro[/caption]
At the money implied vol in February is about 40. Expect to see that come in to the mid to low 20’s following the report.
My View into the Print: Let’s do a little bull/bear debate.
Bull: Fortress balance sheet, attractive dividend and buyback yield, very sound technical set up, apparent strong migration trends towards higher margin Office products and healthy Commercial Cloud growth. The stock screens as defensive….despite
Bear: historically rich valuation to the broad market and its peers, weak growth prospects, likelihood of large acquisition to re-invigorate growth, material headwinds from weak emerging market demand, strong dollar (55% of their sales are outside the U.S), weak enterprise demand, collapsing PC demand, slowing smartphone demand and I think I am still missing some.
Conclusion: So sentiment is positive, and the stock’s ability to remain a relative strength leader is very much tied to the company’s guidance for cloud offerings and their resilience to weak demand resulting from what appears to be a weakening global economy.
So What’s the Trade?
If MSFT makes a move like FB it could take it back near its recent highs. So a good spot to target with defined risk is $55:
Bullish/ Stock Alternative
Buy the MSFT ($51.80) Feb 50/55/60 call butterfly for 1.65
- Buy 1 Feb 50 call for 2.85
- Sell 2 Feb 55 calls at .65 each (1.30 total)
- Buy 1 Feb 60 call for .10
Break-evens on February expiration:
Losses: of up to 1.65 below 51.65 with total loss of 1.65 below $50. Loss of up to 1.65 above 58.35 with total loss of 1.65 above $60.
Gains: of up to 3.35 between 51.65 and 58.35 with max gain of 3.35 at 55 on February expiration.
Rationale – This defines risk to 1.65 in the stock, much less than the implied move and effectively buys the stock for a move higher to 55 slightly below where it is currently trading (breakeven is 51.65) The tradeoff for defined risk is that if the stock goes significantly higher than 55 the profits trail off.
Bearish: sell short dated weekly puts to finance longer dated ones targeting the implied move.
Buy MSFT ($51.80) Jan29th weekly / Feb 49 put calendar for 50 cents
- Sell to open 1 Jan29th weekly 49 puts at 45 cents
- Buy to open 1 Feb 49 put for 95 cents
Break-Even on Jan29th weekly expiration:
Profits: Max profit at 49 very near the implied move for earnings. If the stock is lower but above 49 on tomorrow’s close then you would look to turn Feb puts into a vertical.
Losses: A big move higher or a move lower significantly below 49 and the .50 is at risk.
Rationale – Implied vol is high in the stock going into earnings. This finances puts for a move lower by selling the even higher priced weeklies. This is mildly bearish on the event itself and then aggressively bearish after the event if there is a small move lower as the short weekly puts will expire on Friday.