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Why Microsoft Stock Could Surge after Its Earnings

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Microsoft (MSFT) shares have returned 0.5% over the past month. The return shows that the company is outperforming the US software industry’s loss of 2.9%. Notably, Microsoft returned 30.2% over the past year. The stock outperformed the software industry, which returned 21.7%. The company is scheduled to report its earnings for the first quarter of 2020 after the market closes on October 23.  

Analysts expect Microsoft’s EPS to be $1.24, which is 28.69% more than the same quarter the previous year. Options markets have priced in a 5% move in October.   

Microsoft’s key growth driver

In my view, the Intelligent Cloud segment is the company’s key growth driver. Intelligent Cloud revenues increased 21% YoY in fiscal 2019. The revenues made up around 30.9% of all Microsoft’s revenues in fiscal 2019 compared to 29% in fiscal 2018. The Intelligent Cloud segment continues to gain a share in the company’s revenues year-over-year and still has a long runway of expansion ahead.

I think that Microsoft’s Intelligent Cloud business will continue to boost the company’s growth. Many analysts expect the Global Cloud AI market to grow at a CAGR of about 20% over the next five years. According to Fortune Business Insights, the AI Cloud Market could $202.57 billion by 2026 and grow at a CAGR of 33.1%.

How’s the company’s valuation?

The stock is trading at 25.97x its fiscal 2020 earnings estimates of 5.26. Microsoft looks undervalued compared to the sector’s median forward PE ratio of 28.03x. The company’s PE ratio has been as high as 50.78 and as low as 5.5 with a median of 14.5. If the company starts to trade closer to the sector’s median levels, the stock price could be around $147.3—a gain of 6.5% from the current levels. 

In addition, Microsoft trades with a PEG (price-to-earnings growth) ratio of 0.2x, which suggests that the stock is currently undervalued given a PEG ratio of 1–1.5 for a fairly valued stock. 

Finally, Microsoft has a solid margin profile with 65.90% gross, 34.14% operating, 43.35% EBITDA, 31.18% net, and 24.58% free cash flow margins. These figures substantially outperform the industry’s median. The industry consists of 47.45% gross, 4.4% operating, 10.39% EBITDA, 2.47% net, and 6.49% free cash flow margins.  

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Source: Think or Swim

Technical analysis

The daily chart shows what’s going on with Microsoft. Currently, the stock is floating around the 50-day simple moving average. Since June, the stock has been flattening in the $130.00–140.00 range. The equity is also trading 3% off the 52-week high reached in July. In the near term, the stock might rally to the technical resistance level of $140.00. Breaking this level would send the stock close to its previous high of around $142.3. However, not breaking above $140.00 would lock the equity in the $130–$140 range. The chart also shows that the money flow index value of 38.31 is below its relative strength index of 51.85, which indicates more conviction to the plausible rally.  

Options analysis for Microsoft stock

The implied volatility for the options at the $139 strike price, which expires on October 25, stands at 31.76%. Investors expect an event that might cause modest movement in one direction or the other.

Based on the October 25 options, I see a bid/ask for the $139 CALL option of $3.05/$3.80. I see a bid/ask for the $139 PUT option of $3.65/$3.95. Remember that the options strike closest to the previous Microsoft closing price of $138.24. You can calculate the expected price move using the mid prices of these options:

3.8 (139 Put) + 3.425 (139 Call) = 7.225/138.24 = 5.2%

Based on the options, the stock could rise or fall ~5% by the October expiration date from the $139 strike price using the long straddle strategy. The stock would be in a trading range of $131–$145.15 by the expiration date. Also, the calls at the $139 strike price outweigh the put options about 12 to 1 with 3,596 open calls to 292 open puts. A buyer of the calls would need the stock rise to $142.8 by the expiration date—a gain of about 3.3% from the stock’s current price.  

My recommendation

Currently, with Microsoft stock at levels of $138.24 per share, I think that it’s a “buy.” I expect the stock price to be $140.00. The stock price assumes a resurgence to the technical levels given the appealing valuation, optimistic option bets, and bullish technical chart. According to TipRanks, Microsoft is a “strong buy” with an average target price of $156.67 and a 13% upside.

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