August 26, 2010 - 11:36pm EST by
2010 2011
Price: 23.78 EPS $2.10 $2.40
Shares Out. (in M): 8,600 P/E 11.3x 9.9x
Market Cap (in $M): 204,508 P/FCF 10.8x 9.5x
Net Debt (in $M): 36,788 EBIT 24,100 27,000
TEV ($): 167,800 TEV/EBIT 6.7x 6.2x

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Selling expensive out of the money MSFT puts and using the proceeds to buy cheap out of the money MSFT calls allows an investor to participate in the upside of the one of the world's most dominant, cash flow producing franchise, and get paid to do so. 

Specifically, one can sell the $17.50 Jan 2012 puts for $1.47 and buy the Jan 2012 $30.00 calls for $1.25 and pocket a $0.22 net premium. At the Jan 2012 expiration, you do very well if the stock closes over $30.00, earn a little more than you would on cash between $17.50 and $30.00, and only lose money below $17.25, which is 28% below the current price.  Those with higher risk tolerance can sell $20.00 puts instead and collect a $0.98 net premium.  I believe that the only likely scenario where an investor would lose a signficant amount of money on this investment at option maturity as it is structured is for MSFT to experience a 30-50% decline in expected earnings. If that were to happen, we will all have more important things to worry about than the performance of this investment.

Microsoft is a very cheap stock.  At $23.75, the stock trades at less than 8x June 2011 free cash flow per share of $2.50 ($2.40 concensus plus $0.10 of excess D&A) excluding $4.25 cash on the balance sheet. The company should grow that free cash flow per share in the low double digits for the next several years due to revenue growth from the new product cycle (MS Office 2010, MS Windows #7) and some share repurchases.

Rather than regurgitating all of the specifics of the company, I will admit that I have no unique insight on MSFT and would refer you to any of the 30+ sell side analysts, as well as several well written reports on value investors club and in the following forums:

What is the appropriate valuation for Microsoft? Given its consistently stable cash flows, I would compare MSFT to a 10 year AAA bond with upside coming from growth and the likelihood of pricing power (inflation protection) offset by the risks of deterioration in their franchise that is an inherent risk in any technology company.

The current 10 year AAA Bond yields 2.75%. If we were to assume that the benefits and risks of owning MSFT vs. a bond roughly offset each other, we could apply that same yield to MSFT equity, we could get to an a valuation in excess of  $95/share.

Recognizing the absurdity of that valuation and that the bond market may currently reflect non-fundamental factors (quantitative easing) or actually does reflect fundamentals (and earnings of the most dominant US companies should be cut by 20%), a more conservative and higher free cash flow yield or lower free cash flow estimate is probably more appropriate.

See the chart below. Assuming that a "normal" 10 year treasury bond should be 5% and that a AAA bond should trade 100 bps over, a 6% FCF yield gives MSFT a $46 valuation. Assuming that we are in for another recession, a 6% FCF yield after a 20% haircut to free cash flow gets us to $37.50. In either scenario, you would profit handsomely from this trade.

What would have to happen to lose money with this trade? At $2.50 of FCF, the stock would have to trade down to a 20% FCF yield.  Alternatively, let's assume we experience another severe economic downturn while Apple takes significant share as MSFT products become increasingly obsolete. Taking a 50% haircut to free cash flow ($1.25) along with a 10% FCF yield, we would still only lose mildly on this investment.

FCF/Share FCF Yield Value Cash Total Value
$2.50 2.75%          90.91            4.25          95.16
$2.50 6%          41.67            4.25          45.92
$2.50 8%          31.25            4.25          35.50
$2.50 10%          25.00            4.25          29.25
$2.50 15%          16.67            4.25          20.92
$2.50 20%          12.50            4.25          16.75

FCF/Share FCF Yield Value Cash Total Value
$2.00 2.75%          72.73            4.25          76.98
$2.00 6%          33.33            4.25          37.58
$2.00 8%          25.00            4.25          29.25
$2.00 10%          20.00            4.25          24.25
$2.00 15%          13.33            4.25          17.58
$2.00 20%          10.00            4.25          14.25

FCF/Share FCF Yield Value Cash Total Value
$1.25 2.75%          45.45            4.25          49.70
$1.25 6%          20.83            4.25          25.08
$1.25 8%          15.63            4.25          19.88
$1.25 10%          12.50            4.25          16.75
$1.25 15%            8.33            4.25          12.58
$1.25 20%            6.25            4.25          10.50


  • New product cycle
  • Share repurchases
  • The possibility that we do not enter a depression
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