/Microsoft%20Corporation%20logo%20on%20sign-by%20Jean-Luc%20Ichard%20via%20iStock.jpg)
Today's large unusual volume in Microsoft Corp (MSFT) call options shows that some investors are bullish long-term on MSFT stock. The stock tanked after its Q3 earnings, so buying long-dated in-the-money calls is an easy way to play this.
MSFT is at $416.44 in midday trading on Nov. 6, well off its price of $432.53 just before releasing its Q3 results on Oct. 30. These in-the-money call options buyers must believe that the stock's drop has been overdone.
This can be seen in today's Barchart Unusual Stock Options Activity Report. It shows that the volume in these calls is over 52 times the prior outstanding number of contracts.
The strike price for over 40,000 call options contracts in MSFT expiring Feb. 21, 2025, 107 days from now, is $405 per share. That means these call options are already over $11 per share in the money. This is known as intrinsic value, since if the calls were to expire today they would still be worth $11.53 (i.e., $416.53-$4.05.00).
However, the midprice of these calls is $30.43 per call option. This has $18.90 in extra or “extrinsic” value (i.e., $405+$30.43, or $435.43 - $416.13 = $18.90), or +4.54% higher breakeven. In other words, MSFT stock has to rise over 4.54% to $435.43, before the call buyers will have any profit.
However, there is plenty of time for this to happen - over 3 months before these options expire on Feb. 21. This means that these call buyers are very bullish on the stock.
And why not? Microsoft produced essentially very strong earnings and cash flow results. Let's look at those results now.
Strong Cash Flow Results
Microsoft reported that its Q3 revenue rose 16% YoY from $56.5 billion to $65.585 billion and diluted earnings per share (EPS) was up 10% YoY. Moreover, its operating cash flow (OCF) was up 11.77% in Q3 (i.e., $34.183 billion vs. $30.583 billion).
This resulted in a strong OCF margin as well. For example, its OCF margin was an amazing 52.1% (i.e., $34.183b / $65.485b). That was on par with last year's 54.1% OCF margin - both well over 50%.
This allowed the company to spend even more on capex for its AI and data center buildout. Capex rose over 50.4% from $9.9 billion in Q3 last year to almost $15 billion ($14.923 billion). As a result, free cash flow (FCF) - which is what is left from OCF after capex spending - fell from $20.67 billion last year to $19.257 billion.
That is still a very strong FCF result. This represents a very high 29.2% FCF margin on sales. Here is how that could lift the company's value going forward.
Projecting FCF
Analysts now estimate that sales for the year ending June 30 2025 will be $278.62 billion and the following year $319.05 billion. That implies that the next 12 months (NTM) sales will average almost $300 billion (i.e., $298.8 billion).
So, assuming that the OCF margin stays at 52% over the NTM period, operating cash flow could reach $156 billion (i.e., $300b x 0.52). And if we expect quarterly capex spending to average $15 billion, or $60 billion annually, free cash flow (FCF) could be $96 billion. That would be a huge FCF margin of 32% (i.e., $96b/$300b).
This would have a huge upside effect on MSFT stock. Here's how.
Price Targets for MSFT
In the last 12 months (LTM), Microsoft has generated $72.66 billion in FCF, according to Seeking Alpha. This represents 2.35% of its $3,096 billion market cap.
Therefore, using a 2.35% FCF yield metric (the same as multiplying FCF by 42.553x, the inverse of 2.35%), Microsoft could end up with a market cap of $4,085 billion (i.e., $4.085 trillion). This is seen by multiplying $96 billion in NTM FCF by 42.553x .
That is 31.9% higher than its $3.09 trillion market cap. In other words, MSFT stock is worth 31.9% more than today's price of $416.13 per share, or $548.88 per share.
Analysts tend to agree that MSFT is too cheap here. For example, Yahoo! Finance shows that analysts' average price targets is $495.78 per share, or up +19.0%. Similarly, Barchart's survey shows a mean target of $504.59 per share.
Moreover, AnaChart.com, a new sell-side analyst tracking site, shows that the average of 37 analysts is $467.90, or +12.3%.
The bottom line is that MSFT stock looks too cheap here. No wonder some large investors are buying long-term call options with in-the-money strike prices.
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.
