MicroStrategy: An Enterprising Small-Cap

MicroStrategy Inc. (MSTR) provides business intelligence software that allows companies to report, analyze, and utilize data from their customer transactions to improve business decisionmaking. Their Web-based architecture offers reporting, security, performance and standards for optimal web business effectiveness.

Revenues have been growing strongly for this debt-free, cash-rich company.

Sales more than doubled from $147.8 MM in 2002 to $350.7 MM in 2007. Treasury cash has been building, too. It totaled $79 MM at year-end 2006 and swelled to $99.9 MM as of March 31, 2008. With only 11.927 MM shares outstanding that comes to $8.37 /share.

EPS were $4.55 last year and analyst estimates for 2008 now run from $4.57 to $4.86. The slowdown in earnings growth is the result of increased worldwide employee headcount to facilitate the expansion of MSTR's sales and service capabilities. That pushed operating expenses up which offset a 33% increase in licensing revenues in 2008's Q1. Preliminary expectations for 2009 range from $5.43 and $5.55 /share.

At its peak share prices in 2005-2006-2007-2008 MicroStrategy traded at 20x – 25.6x trailing earnings. Right now it's offered at < 16.9x trailing EPS.

A return to even 19 times the mid-point 2008 estimate of $4.72 would see these shares return to about $90. That's not hard to imagine as MSTR shares actually hit levels of $129.88, $133.12 and $96.15 in 2006, 2007 and 2008 year-to-date respectively.

Here's a stock and option combination play with MSTR that looks good to me at current prices:

……………………………............………………Cash Outlay……..Cash Inflow

Buy 100 shares of MSTR @ $76.49 …….... $7649

Sell 1 Jan. 2009 $75 call @ $12.00 /sh. ………………………. $1200

Sell 1 Jan. 2009 $75 put @ $9.30 /sh. …………………………. $930

Net Cash Outlay …………………………............ $5519

On expiration date if MSTR shares remain above $75:

Your shares will be 'called' for $75 /share or $7500.

Your put option will expire worthless [a good thing for you- the seller].

You will own no shares and have no further option obligations.

You will have $7500 for your original net cash outlay of $5519.

That is a profit of $1981 on $5519 cash-on-cash or + 35.8% for just about eight months. This return is achieved if the shares go up, stay unchanged or even if they decline to $75 [a 1.9% drop].

What's your breakeven on this trade?

On the shares purchased:

$76.49 [original cost] less $12 [call premium] = $64.49 /share

On the put you sold:

$75 [strike-price] less $9.30 [put premium] = $65.70 /share

Average break-even is $64.49 + $65.70 / 2 = $65.10 /share

You are in profit as long as these shares don't drop more than $11.39 or more than 14.8% between now and next January 16^th.

Disclosure: Author is long MSTR shares and short the MSTR options mentioned.

Comments

[p. smith]

MSTR needs to be a bigger scale to be a more significant player just like i2 Technologies does.

i2 has turned-around and a fast cash generator, very profitable too; best of all i2 carries a $1.8 billions tax credit.

The two should merge.

[Chungst]

The problem with trades like this one -- long 100 shares of a stock and short a straddle at or near the money strikes(1). Let's think about this for a second, you face 3 bid-ask spreads (as wide as $0.40 on the call side), you face 3 transaction costs, and you face short-term taxes on the options. The cash on cash return (1) is nice before commissions and taxes, but after these frictional costs, the trade is less desirable.

The downside risk is that you have no idea as to the intrinsic value of MSTR so you are automatically assuming the about 15% price decline is an adequate cushion. Second, you looked at MSTR's historical valuation and you also assumed that was the correct valuation (stocks could be overvalue for long periods of time as evidenced by the dot com bubble!). Then you are hoping for the current P/E to expand to 19x.

The first test would be a common sense test regarding risk and return, i.e. the ratio of upside return to downside risk. Since you never calculated the intrinsic value, you don't know the downside risk -- (btw, the intrinsic value should include the "$8.37" cash per share price). Therefore, you know your upside is capped at $19.81 a share but don't know your dowside risk (in theory, the loss could be $68.12).

It's clear why people are so tempted by options, they can see the upside potential but fail to see the down
risks involved. The reason why the cash on cash returns (1) looks so attractive is due to the excessive risks taking you are undertaking.

Cheers.

(1) The trade assumes the buyer has a margin account and sufficient buying power or capital to put on the option-side of the 3-legged trade. The actual return calculation needs to factor in this capital (which the author omitted), otherwise it distorts the true return calculations, i.e. the cash on cash return is ARTIFICIALLY INFLATED due to understating true capital requirement. Anyone can have inflated returns by omitting some or most capital required for the trade.

[Paul Price]

I actually got better prices than described in my posting for exactly those trade early yesterday. I could should you copies of my confirms if that's what it takes to prove the prices were legit.

Commissions are a non-factor for me. I pay $1 per contract or less for option trading [with a $1 minimum] at InteractiveBrokers and TradeStation. I pay one cent or less per share to trade stocks with them with the same $1 minimum for 100 shares.

You do need a 'margin type' account and paid-up marginable equity to do these trades. You do not need to lay out any cash other than your net purchase price less the option premimums received.

The cash-on-cash return is exactly accurate as written above.

I've been doing this type of trading for almost 30 years. It works.

[Chungst]

Again, you make no comment on taxes (on short term capital gains), which is a big killer on actual returns for options. That is to say your portfolio did not increase by "35.8%" on an after-tax basis.

Second, you still did not address the risk-reward ratio.

Third, if you acknowledge the role of using a margin account, then you must also acknowledge that your cash on cash return is "juiced up" -- i.e. using leverage. The alternative (non-leveraged return) is to use a cash collateral and that would in effect lower the return.

Fourth, if you have been doing these trades for 30 years, all it means is you are comfortable taking this type of risk for 30 years.

Cheers.

[Chungst]

Here's an example to better show the flaws of cash on cash return. Let's say I simply shorted 1 naked put for MSTR for January 2009 at a strike price of 70 for $6.85 (mid-point between current bid of 6.70 and current ask of 7.00) as opposed to the aforementioned 3-legged trade. I chose a strike price of $70 since it is similar to the average break-even price of $65.10. In my trade, my break-even price is $63.15 (the difference between the 70 strike and 6.85 in premium) and is lower to 65.10 price listed in the article.

Under Mr. Price's logic, my cash on cash return ought to be infinite since I collected $6.85 and didn't make any cash outlay since I am using margin. In contrast, my actual cash return is not infinite because of two reasons: (a) my portfolio didn't increase by an infinite amount and (b) if I had to cash collateralize my trade, then my cash return would be some other number much less than infinite.

The reason I sold a naked put is that any stock price above $63.15 means I made a profit (before taxes and commissions) which is similar to the economics of Mr. Price's trade.

The key take-aways are: (a) the need to understand what the real returns are and (b) the need to understand the risk side of the trade. The naked put trade has a higher cash on cash return (because it's infinite versus 35.8%) and it has less risk (because of the lower break-even price) since the option also expires in Jan 2009 meaning it is far superior to Mr. Price's 3-legged trade. However, any intelligent investor who understands the two key take-away points knows better.

Cheers.

[Paul Price]

Your salary is all 'pre-tax' money. Does that make it unattractive?

If you make $635 on the expired option in your example by writing a put against stock you are already holding it is, indeed, a return on a negative cost of capital.

If you want to calculate the return on your theoretical margin requirement of 20% of your net committment of $6315 then the return on that would be $655/$1263 or 51.86% for the eight months until expiration [assuming the shares stay above $70].

[Chungst]

Given a choice of my "salary" taxed at the long term capital tax rate of 15% or the short term rate of 28%, I prefer the "attractive" 15% rate, which is about half the 28% rate. If you make the trade last over 1 year (only 4 months more), then you could save about half of your tax oligations and keep more of the gains. You can always create a synthetic option with a one-year maturity.

Second, it's clear you don't understand GIPS and that's why you mistakenly used levered "cash on cash" returns.

Third, a naked put means I don't own the stock. I chose the naked put since one of your legs in your trade was a naked put (it was part of the straddle).

Fourth, negative cost of capital doesn't make sense. There is a simple proof -- capital costs have opportunity costs associated with them. If you understand GIPS or used cash collateralized options, then you know why.

Fifth, the MSTR options do have wide bid-ask spread (and this negatively impacts those option writers that use market orders). These wide bid-ask spreads are also issue when you close out the option when seeking long-term capital gains treatment.

If my naked put trade has a higher return at "51.86%" (not necessarily agreeing with your number) AND it has lower risks (not to mention lower commission costs and facing only one bid-ask spread, other things being equal), then why would anyone do the three-legged trade and use so much capital in the first place??

Based on your responses to date, it's clear you didn't realize the risks involved and that you don't have a good grasps of return calculations -- the original cash on cash return number was very misleading (i.e. due to leverage, etc).

Cheers.

[Chungst]

"I've been doing this type of trading for almost 30 years. It works."

It has been brought to my attention that I overlooked this comment. Mr. Price writes that this type of trading "works" -- however, he doesn't say if it works 50% of the time or 80% or 20% of the time. What I have commented on earlier is that the strategy is not tax efficient and that Mr. Price engaged in this type of trade without fully knowing the risks as well as the correct returns (since he was incorrectly using cash on cash returns).

Unbeknownst to Mr. Price, he was engaging for 30 years in a "trade" without knowing the true risk reward trade-off. The sad part is that there were red flags or warning signs that the trade was too good to be true. The general rule in investing is that if you take risks, then you must be fully compensated for the risks involved.

Cheers.

[Paul Price]

Chungst,

No matter how much time you are short a stock or an option it always will be taxed as a short-term transaction. You cannot have a 'holding period' on a short position.

[Chungst]

Mr. Price:

Again, you keep putting words in my mouth or deliberating twist my words. I never stated that you short a stock.

You did originally write in your piece, that you want to buy a stock -- not short a stock. Please GET YOUR FACTS CORRECT!!

Cheers.

[Paul Price]

When you sell puts and calls you are SHORTING those securites. YOu cannot get a long-term transaction from a short sale even if you don't close it out for more than a year.