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A large unusual tranche of Microsoft Corp (MSFT) put options traded today. These puts are out-of-the-money (OTM) and could be a bullish trade. MSFT stock continues to look undervalued given its strong free cash flow.
MSFT is at $443.84 in midday trading, up from a recent low of $415.67 on Jan. 14. The stock continues to look undervalued to value investors and could be worth over $561 per share over the next year, or an upside of 26.5%.
That implies a potential 24% upside over the next year. It is based on the company's strong free cash flow (FCF) and FCF margin outlook. This article will delve into how this works out.
That could be one reason why the large tranche of OTM puts traded today.
Unusual Put Options Activity
The Barchart Unusual Stock Options Activity Report today shows that over 6,000 put option contracts were traded for the Jan. 24 expiration period. That represents over 51 times the prior number of outstanding contracts.
This shows that this is indeed an unusual put option activity.
Note in the table below that the strike price of these puts is well below today's trading price. That means that they are out-of-the-money (OTM). In other words, MSFT will have to fall in the next two days before the buyers of these puts will have any intrinsic value.
This implies that the short sellers of these puts are willing to collect the put premiums by securing cash to act as collateral for this play. For example, the $1.58 midpoint premium represents 0.36% of the $437.50 put strike price. That means an investor has to secure $43,750 per put contract shorted, in order to earn $158.
However, given that there are only 2 days left until expiration this represents a high expected return (ER) if it can be repeated. For example, if done every week for a year, that works out to an 18.72% annualized ER:
($158 x 52) / $43,750 = $8,216 / $43,750 = 0.1878 = 18.79%.
Moreover, these investors appear happy to buy MSFT shares at $437.50 per share. They must believe that the stock could be worth much more. Let's look at why.
Microsoft's Strong FCF
Last quarter Microsoft reported on Oct. 30 that its Q3 revenue rose 16%, but more importantly its operating cash flow (OCF) margin was an amazing 52.1%:
$34.183 billion OCF / $65.485 billion Q3 revenue = 0.521 = 52.1% OCF margin
After spending $14.923 billion in capex (due to AI and data centers), its free cash flow represented 29.4% of sales:
$34.18b OCF - $14.923 b capex = $19.23b FCF
$19.26b FCF / $65.485b revenue = 29.4% FCF margin
We can use that to project out FCF going forward. For example, analysts now forecast sales ending June 2025 will be $278.5 billion, and the next year will rise to $318.5 billion.
That means that the run rate revenue over the next 12 months (NTM) will be about $300 billion.
Therefore, if we assume that the OCF margin will be 52% of sales, its operating cash flow will be:
0.52 x $300b est. NTM sales = $156 billion OCF
And, after deducting slightly higher capex spending of $16 billion per quarter:
$156b OCF - ($16 x 4) capex = $156b -$64b = $92 billion NTM FCF
That represents 30.67% of its est. NTM sales, which is higher than its recent 29.4% FCF margin.
As a result, we can estimate a higher stock price target.
MSFT Stock Price Target
One way to value a company with strong FCF and FCF margins is to use an FCF yield metric. For example, its FCF generated over the past year ($72.66 billion), according to Seeking Alpha data, represents 2.20% of its existing market value:
$72.66 b / $3,290 b market cap today = 0.02208 = 2.21% FCF yield
(Note this is the same as multiplying FCF by 45x, since 1/0.0221 = 45.25)
Therefore, if we apply this to our estimate for NT FCF, we can project Microsoft's market value over the next 12 months:
$92b FCF / 0.0221 = $4,163 billion project market cap
This represents a 26.5% potential upside in the market value for MSFT stock:
$4,163b NTM mkt cap / $3,290b today = 1.265 -1 = 0.265 = +26.5%
In other words, the MSFT price target is worth 26.5% more, or $561.46:
$443.84 x 1.265 = $561.46 per share
Summary
Here is what that means. It assumes Microsoft can continue to make 52% operating cash flow margins. If its capex spending rises to $64 billion annually, its FCF margin could exceed 30% of sales.
That could lead to $92 billion in FCF over the next 12 months. Therefore, using a 2.2% FCF yield metric (i.e. 45x FCF), the market cap could rise by 26.5%. That implies a price target of over $561 per share.
In fact, given Microsoft's strong share buybacks, the price target could be even higher.
The bottom line is that short-put out-of-the-money (OTM) plays in nearby expiry periods in MSFT stock look like a good play here. That could be one reason why today's Barchart Unusual Stock Options Activity Report shows large unusual OTM put activity.
