$MSFT – Clouded Azure’s Profitability Is

by Dan June 2, 2016 1:04 pm • Commentary• Trade Ideas

On May 19th, I laid out my near term bearish thesis for shares of MSFT (Clouded by Azure), highlighting investor focus on their public cloud business and valuation:

Despite fast growing businesses like Office 365 growing 63% in the March quarter, within the Productivity group, and with Azure (MSFT’s AWS competitor) growing 120% in the quarter within their Intelligent Cloud division, the overall groups saw just 1% and 3% year over year sales increases.  The point here is simple, while MSFT has some fast growing businesses, they are a still a small-ish part of a $90 billion revenue machine, that is NOT growing.  Following their disappointing fQ3 results, shares of MSFT declined the next day 7%, are now down 10% from the close prior to earnings on April 21st, and down almost 13% from their 52 week and 15 year highs made in late Dec 2015.

Here is a big problem with MSFT. The stock trades nearly 19x expected fiscal 2016 eps growth of 1%, and 17.5x expected 2017 eps growth of 8%. I am not really sure why this stock should trade at a significant premium to most mega-cap tech peers (CSCO and INTC at 12x expected 2016 eps, with low single digit growth).  Yeah, Yeah, balance sheet, capital return, and to be fair I’d rather own MSFT to consumer staples like KO or PG which have similar yields but higher valuation, but I suspect 2016 is going to see continued strain for Enterprise Tech spending, and MSFT will not be immune these pressures

At the time the stock was $50 (now $52.40) and I did not think banging on technical support was a good short entry, and wanted to wait for a bounce.

Today, there were a few pieces of news that caught my eye relating to MSFT.

First, was a a research report from Citigroup analysts Mark May and Walter Pritchard, detailed by Tiernan Ray in a Barron’s Online post on the “state of cloud computing”, which reinforces the consensus opinion that Amazon’s AWS rules the public cloud and MSFT & GOOGL are second tier players:

For MSFT, we note that investing heavily in and shifting customers towards Azure is the only choice it has from a strategic perspective. Though, MSFT’s competitive position in the cloud infrastructure market is fundamentally worse than its on-prem positioning from both a market share perspective as well as its mindshare with developers.

And here is the thing. We know that AWS’s 28% operating margins is a large contribution to AMZN’s new found (albeit slight) profitability, it is important to note that margins have declined (also slightly) in the last two quarters. Why? Well, it could be simply that MSFT and GOOGL are becoming more competitive on pricing. When it comes to MSFT it is widely thought that their Azure business is. Despite growing 120% year over year in their latest quarter (fiscal Q3), operating margins in the Intelligent Cloud group (total revenue of $6 billion in fQ3) where Azure is bucketed, saw operating margins badly miss expectations of about 40%, coming in at 35.9%. This could signal a more aggressive tone by MSFT in an attempt to gain market share from AWS.

And then this Bloomberg story: Microsoft Board Mulls Sales Force Revamp to Speed Shift to Cloud. It states very clearly that its not just growth of cloud based products the company needs for market share purposes, but board Chairman John Thompson suggests cloud growth:

it’s critical against the backdrop of declining demand for what’s known as on-premise software programs, the more traditional approach that involves installing software on a company’s own computers and networks. No one knows exactly how quickly sales of those legacy offerings will drop off, Thompson said, but it’s “inevitable that part of our business will be under continued pressure.


The board is examining whether Microsoft has invested enough in its complete cloud lineup, Thompson said. It’s not just about developing better cloud technology — it’s a question of how the company sells those products and its strategy for recruiting partners to resell Microsoft’s services and build their own offerings on top of them. Persuading partners to develop compatible applications is a strong point for cloud market leader Amazon.com Inc., he said.

It appears that MSFT, despite a sort of resurgence since CEO Satya Nadella (former head of MSFT’s cloud division) took the helm in early 2014 is faced with a sort of existential crisis about how they sell software, and how they plan to deliver services to enterprise customers.  I suspect continued declines in operating margins at AWS, and in MSFT’s Intelligent Cloud group when these companies report (MSFT – July 19th and Amazon July 21st) might confirm a period of increased competitiveness and the start of lower profitability for these businesses, despite a rapidly expanding market opportunity.

I can’t be much help on AMZN from an investment standpoint, it’s not a good stock with me, on my banned list so to speak. But with MSFT trading close to 20x 2016 eps, I suspect lack of transparency about Azure margins, and continued pressure on the group in which they fall could cause investors to re-rate the stock somewhere closer to a market multiple, which would place the stock in the mid to high $40s depending on whether you apply 16.5x trailing or expected fiscal 2017 eps.

So what’s the trade?  

It makes sense to target MSFT’s fiscal Q4 earnings results on July 19th, but with an eye towards financing near the money puts.

*Trade: MSFT ($52.40) Buy June / July 22nd weekly 51 Put Calendar for 95 cents

-Sell to open 1 June 51 put at 30 cents

-Buy to open 1 July 22nd weekly 51 put for 1.25

Break-Even on June Expiration:

Max profit at or just above $51 as the June put will expire worthless, offsetting some decay of the July 22nd weekly 51 puts, which will also gain value from an increased delta.

Worst case scenario is MSFT rallies well above $51 and both puts lose most of their value, but in either direction, the max risk is the 95 cents in premium spent.

Trade Management: as we get closer to June expiration, if the June 51 puts are worth pennies we will likely cover them and look to turn the July 22nd weekly 51 puts into another calendar, selling other weeklies, depending upon where the stock is, or into a vertical calendar by selling a lower strike put in July 22nd expiration.

This trade idea is ultimately targeting a gap fill from October near $47:

MSFT 1yr chart from Bloomberg
MSFT 1yr chart from Bloomberg