Microsoft (MSFT) produced excellent results on April 25 for its fiscal Q3 ending March 31. Moreover, the $3 trillion market cap software company showed higher free cash flow (FCF) despite increased capex spending based on its focus on integrating artificial intelligence (AI) into its product line.
This makes MSFT look undervalued here and provides a good opportunity for out-of-the-money (OTM) short-put investors. As a result, MSFT stock is trading about 2.0% higher in morning trading on April 26 at $409 per share.
For example, in a recent April 12 Barchart article, I wrote that MSFT could be worth substantially more: “Microsoft Stock Is Undervalued Here, and Selling Short OTM Puts For Income is Attractive.” I also pointed out in that article that the $395 and $400 strike price put options expiring May 3 were worth shorting for income and as a good buying entry point.
It makes sense to roll these out-of-the-money (OTM) put options forward to a new expiry date. I will discuss this below, but first, let's review the company's excellent FCF results.
Microsoft's FCF Margins Expand
Microsoft reported on page 6 of its PowerPoint presentation that its FCF hit $21 billion in the quarter ending March 31. That was significantly higher than last year (up 18% Y/Y) and even compared to last quarter's $9.1 billion FCF results (up 130% Q/Q).
Moreover, this was even though its capex spending in the quarter rose 12.5% Q/Q from $9.735 billion to $10.95 billion, and much higher than last year's quarterly capex ($6.6 billion). These increases are based on its AI product integration spending. The CFO, Amy Hood, said its AI spending would continue to “increase materially.”
Free cash flow is measured by deducting capex spending from operating cash flow. So, as long as Microsoft can keep showing higher FCF results, despite higher capex spending, the market will likely value the stock higher.
For example, this quarter the company's FCF margin was 33.9% (i.e., $20.965 billion FCF / $61.858 billion in revenue). This was higher than last year's fiscal Q3 FC margin (33.7%) as well as the prior fiscal quarter (Q2 FCF margin was 14.7%). Moreover, for all of FY 2023, its FCF margin was 29.6%.
My recent April 10 GuruFocus article on Microsoft argued that MSFT stock is worth over $500 per share ($503.83) using an assumption of 28.6% FCF margins. However, the company's 9-month FCF margins this past quarter ending March 31 were 28.1% ($50.75 b FCF/180.4 b revenue) vs. last year's 21.0% ($32.65 b/$155.7 b). That shows that FCF margins so far this year, despite higher capex spending are up 33.8%.
As a result, I believe my original price target of $503 per share stands, and this implies that MSFT stock is 22% undervalued. That makes selling short OTM puts worth doing.
Shorting OTM Puts
For example, look at the May 17 expiration period, three weeks away from today. It shows that the $400 strike price put option trades for $5.60 and the $395 is at $4.15, both on the bid side. These strike prices are about 2% and 3% out-of-the-money, respectively.
As a result, a short-put investor can make an immediate yield of 1.30% at the $400 strike price (i.e., $5.20/$400) and almost 1.0% (i.e., 0.96%) at $395 (i.e., $3.80/$395.00). This works well for existing investors who might already own MSFT shares and are looking to make extra income.
They also might not be bothered about having to buy more shares if the stock falls to the strike prices on or before the expiration period. This is better than selling covered calls where there is a risk that their shares could be sold if the stock rises.
Moreover, these are good entry points for new investors in MSFT stock. For example, the breakeven buy price with the $395 strike price is $390.85 (i.e., $395-$4.15). That means that at the target price of $503, the investor will make a 29% expected return.
The bottom line is that MSFT looks very cheap here given its high FCF margins and shorting OTM puts is a good way to play this.
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On the date of publication, Mark R. Hake, CFA did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.