$MSFT – Partying Like it’s 1999

by Dan April 21, 2016 2:19 pm • Commentary• Trade Ideas

Event: Microsoft (MSFT) reports fiscal Q3 results tonight after the close. The options market is implying about a 4.3% one day move, which is well below the 4 qtr average one day move of about 7.5%, and inline with the 10 year average of about the same.  Its important to note that on two instances in the last 4 quarter the stock has rallied 10% the day after earnings.  

Price Action / Technicals: Shares of MSFT are flat on the year, but up about 16% from its 2016 lows made in February, and now down only about 2% from its 52 week highs made in late 2015, and about 7% from its all time highs made on the eve of YTK back in late 1999:

[caption id="attachment_63045" align="aligncenter" width="600"]MSFT 16 yr chart from Bloomberg MSFT 16 yr chart from Bloomberg[/caption]

Capital Return: remains one of the largest reasons to stay long and strong.  But here is a little fun fact, the last time MSFT sniffed $60 it was the day before Y2K, the year the company reached $20 billion in annual sales. They are expected to have close to $95 billion this year. While that is truly remarkable, it is not an apples to apples comparison when you consider just how much stock the company has returned (about $95 billion) to shareholders in the form of buybacks and dividends in just the last 6 years, from Microsoft Investors Relations:


My View: MSFT’s gross margins have had 5 consecutive annual declines since their recent fiscal 2010 peak at 80%, with fiscal 2016 expected to be a tad below 65%.  This is and should be the main concern of investors as the company wants investors to focus more on the growth in their Office 365, their cloud based Office offering, hoping to offset the expected weakness in Windows (Gartner sees down 7.5% this year to $13.5 billion), which faces continuing pressure from the nearly  10% decline in PC shipments year over year in Q1.  So its CLOUD, CLOUD, CLOUD. Everyone is chasing Amazon’s 30% plus market share with AWS, almost more than MSFT, IBM and GOOGL combined, per Market Realist:


The stock is trading 20x fiscal 2016 expected earnings growth of 5%, a P/E nearing a 10 year high. That seems a bit excessive, especially if you are skeptical that fiscal 2017 consensus earnings growth of 10% is achievable.  I suspect that despite MSFT’s growth in cloud businesses, those chasing AMZN will increasingly have to compete on price to take share, and the margins that first movers are benefiting from to offset legacy businesses will be canceled out to some degree, suppressing eps growth.

With the stock near the top end of the one year range I would expect a breakout at some point soon, but I am not playing for one. I would be far more inclined to buy the stock closer to $50, very near its rising 200 day moving average:

[caption id="attachment_63047" align="aligncenter" width="600"]MSFT 1year chart from Bloomberg MSFT 1year chart from Bloomberg[/caption]

So What’s the Trade?

As I said, I like this stock lower so am not involved at this level. But for those looking to play for new highs into the Summer, one way to do that would be to sell the implied move in the weeklies and buy June upside:

Bullish – MSFT ($55.75) Buy the April22nd/July 57.50 call calendar for .50
  • Sell 1 April22nd 57.5 call at .45
  • Buy 1 April22nd 57.5 call for .95

Rationale – The implied move for the event is about 4%. This targets that move to the upside on earnings itself and leaves optionality for after tomorrow to continue a long trade into June expiration. Ideally the stock would move higher to the 57.50 strike at which point the April weeklies calls would expire worthless, leaving a financed June at the money call that can then be further spread. If the stock goes sideways this trade should do fine as the implied vol difference is large (80 vs 20) and the June vol shouldn’t get killed. The risk to the trade obviously is if the stock goes down. But the most the trade can lose is .50 (and that’s unlikely even on a decent move lower ). That’s in contrast to the risk in the stock which is implying a move of over $2.00.

For those that are already long and would be willing to buy the stock lower, 1×2 put spreads targeting an effective buy just above $50 while offering a bit of a hedge is like a buy order below.

Hedge/ Buy the Dip – Against 100 shares of MSFT ($55.75) Buy the May 55/52.50 1×2 put spread for .25
  • Buy to open 1 May 55 put for 1.29
  • Sell to open 2 May 52.50 puts at .52 (1.04 total)

Rationale – If the stock went to 52.50 on May expiration this trade would provide 2.25 worth of protection against long stock. But it’s not for everyone, because below that level, you are put the stock. So it’s only for people willing to buy more MSFT stock if lower. The 1×2 acts as a hedge until 52.50 and below that is like buying stock for an effective price of $50.25 (the profits on the 1×2 less the amount paid gives you the effective price below the strike that you’d be put the stock.