Microsoft: Profiting From Windows 8 Launch

Aug. 7.12 | About: Microsoft Corporation (MSFT)

While Apple (NASDAQ:AAPL) might be the biggest name on the planet currently, and as a result captures most of the headlines, investors should not ignore Microsoft (NASDAQ:MSFT) over the next couple of months. A few major product launches are scheduled for the second half of 2012, which could boost shares back to their 52-week highs. Today, I'll examine what to watch for, and a few ways to profit from the recent round of news.

Upcoming Product Launches

Obviously, Microsoft's near term future is dependent on the launch of Windows 8. Recently, we've heard that Windows 8 has been released to manufacturing. This means that product development and testing has completed. Microsoft will release the enterprise version for download on August 16, and the consumer version will be available on October 26.

On the same date, October 26, the Surface tablets will also start shipping. While pricing was not released, it is expected that the Surface will probably be priced in the same range as Apple's iPad and the new PlayBook from Research in Motion (RIMM).

Microsoft is entering a very crowded space, but is aiming to challenge current rivals such as Apple. It will be interesting to see how that works out over time. Google (NASDAQ:GOOG) has just launched its Nexus tablet, RIMM is in the process of launching new Playbook versions, and even Amazon (NASDAQ:AMZN) is working on updates to the Kindle Fire. Let's not forget as well, that Apple sold over 17 million iPads in its most recent quarter.

Even if the Surface is not an iPad killer, it still should take some iPad sales away. With the Surface starting to ship at the end of October, Microsoft will have two full selling months in what is going to be a very competitive holiday season for tablet purchases. It will be very interesting to see not only how some of these firms price their models for the holiday season, but to see if there are any additional discounts from retailers, like Best Buy (NYSE:BBY) and others that may be selling these products.

Microsoft has also recently announced four versions of Windows Server 2012, which will be available on September 4. Microsoft's server and tools segment is becoming an increasing force, producing over $5 billion in revenues for the recent Q4. That revenue increase was up more than 12.5% over the prior year period. Additionally, the segment produced nearly $2.1 billion in operating income, up more than $400 million (24.26%) from the year ago period. That also means that margins for the segment have improved from 37.27% to 41.14% over the past year. Not only is this segment growing at a decent clip, but it is becoming a more profitable one as well.

Also, we have heard that Samsung (OTC:SSNLF) is planning on launching two Windows 8 based phones during calendar Q4. This timeline appears to be in line with recent Windows 8 rumors. The release date could be very key for this launch. Apple is expected to launch its new version of the iPhone during calendar Q4. It's possible that the Windows 8 phones could see a slight sales boost if they are released first.

Microsoft As An Investment

Since the Windows 8 launch is scheduled mostly for calendar Q4, analyst projections reflect that. For fiscal Q1 (calendar Q3), analysts are looking for Microsoft to post a 3.1% decline in quarterly revenues to $16.84 billion, along with a drop of earnings per share from $0.68 to $0.59. Last year's period saw $17.37 billion in revenues.

However, for the fiscal second quarter (calendar Q4), analysts are looking for a strong 11.5% growth in quarterly revenues, from $20.88 billion to $23.29 billion. Likewise, earnings per share are forecast to rise from $0.78 to $0.90, a rise of more than 15%.

For the fiscal year ending next June, Microsoft is expected to show revenues increase by 9.1% to $80.42 billion, and earnings per share are projected to increase from $2.73 to $3.03. For the fiscal year ending June 2014, the company is forecast for a 6.6% rise in revenues to $85.73 billion, and earnings per share of $3.35.

Microsoft is also an investor favorite because it pays a decent dividend and is buying back plenty of stock. Microsoft bought back $4 billion of its stock in fiscal 2012, which just ended, and at the end of that quarter, had $8.2 billion left on its share repurchase plan.

The company also pays a 20 cent quarterly dividend, which is expected to be raised later this year. That dividend works out to a 2.67% annual yield based on Monday's close, which is equal to the current yield of the 30-year US treasury bond, for comparison. At the end of the most recent quarter, Microsoft had more than $63 billion in cash, cash equivalents, and short term investments on its balance sheet, up more than $10 billion from the prior year period. It has enough financial flexibility to keep increasing the dividend and buy back stock for years to come.

So where does that leave Microsoft valuation wise? Well, I've compared Microsoft to four large cap tech names: Apple and Google, which compete with Microsoft in various ways, and also Cisco (NASDAQ:CSCO) and Intel (NASDAQ:INTC). The last two are large cap tech names, and Intel is closely regarded with Microsoft as the two best value names in tech land, because of the dividend and buyback.

The following table shows these names, along with their current fiscal year and next fiscal year price to earnings ratios.

Company Fiscal Year End P/E (Current Year) P/E (Next Year
Microsoft June 2013 9.88 8.94
Apple September 2012 14.10 11.85
Google* December 2012 15.11 13.02
Cisco* July 2012 9.12 8.74
Intel December 2012 11.01 10.32
Click to enlarge

*Based on non-GAAP EPS for comparative purposes.

As you can see from the chart, Microsoft is valued closely to Intel and Cisco. Microsoft is growing slightly faster than those two names, and again, has a larger dividend and buyback than Cisco. Apple and Google are growth names at this point, and with both growing faster than Microsoft, each trades at a fair premium to Microsoft.

I would think a fair valuation for Microsoft would be one comparable to Intel. While Microsoft is growing a little faster than Intel, Intel does pay a larger dividend (3.42% current annual yield). Also, Intel is buying back stock a little faster ($1.5 billion in latest quarter), and has a lower market cap, so a billion for Intel will have more effect on shares than a billion for Microsoft. But Microsoft makes up for that with a little extra growth (revenue growth over next two years is about twice that of Intel's). So if you give Microsoft an 11 P/E, you get a target of about $33.33 for fiscal 2013 and $36.85 for fiscal 2014, given currently expected earnings. If the P/E multiple expands, you could get a slightly higher target.

Trade Ideas

Since I expect Microsoft to report its calendar Q4 (fiscal Q2) results the week of January 14 to 18, 2013, all of my options trade ideas discussed will be focused on the January expiration options, expiring at the end of that week. I'm going to suggest a "build-up" trade, meaning that it will have multiple parts. You may only want to do the first part, but adding on the additional parts could be the way to go as well. For this trade, I am assuming 100 shares of stock, and an equal number of calls and puts (1 of each for every 100 shares).

The first part of the trade is simple. You buy Microsoft shares, which closed Monday at $29.95. With this part of the trade, it is easy. You make money if the stock goes up, and lose money if it goes down. Also, for every 100 shares you own, you will get this quarter's dividend, if you buy in the next week, plus the next quarter's dividend (either the .20 per share or whatever it is raised to). So for every 100 shares you own through January expiration, you get a $40 (or more) dividend, depending on if and how much they raise it.

The second part involves selling call options, a covered call strategy. I am recommending selling the $32.50 call, January 2013 expiration, for $0.68 currently. Why that call? Well, the 52-week high on Microsoft is just under $33, and I gave you a target price of $33.33 for this fiscal year, so I have chosen the call just below those values. With this part of the strategy, you pocket $68 for each call you sell, and I would recommend selling an equal number of calls to 100 shares you own. If the shares stay below $32.50 by expiration, and the calls are not exercised, you pocket the $68. If the options are exercised, you are forced to sell your shares at $32.50. But you bought them under $30, and you still keep the $68 premium.

The third part of the trade involves selling put options, in this case, the January 2013 $27 puts for $0.88. In this case, you pocket an $88 premium. If the options are not exercised, that premium goes to you. If the options are exercised, you are forced to buy 100 shares of Microsoft (for each put you sold) at $27, but you keep the $88 premium on each 100 shares, so your true cost basis is $26.12. Combine that with the shares you bought at $29.95, and you've now lowered your cost basis from $29.95 to $28.035, assuming that you sold an equal number of puts per 100 shares bought at $29.95. That also doesn't include the premium from selling calls (if you do that as well), which would lower your cost basis even further.

The chart below shows your profit/loss scenario for this trade, and for simplicity, I have not included commissions, which vary by broker and would lower profits by the total commission amount. For the chart below, I have assumed all three parts: buying 100 shares at $29.95, selling 1 call, selling 1 put, and receiving two dividend payments.

(click image to enlarge)

Click to enlarge

As you can see, your losses increase on the downside, because you lose on both the stock and the puts. The break-even is $27.99. Your gains are capped at $32.50, for a total profit of $451, because your shares are called away above $32.50. At that point, you've made money on the stock, received two dividend payments, and also the call and put premiums.

Conclusion: Watch Microsoft In The Next 5-Plus Months

Microsoft is going to be a name to watch over the next couple of months. Windows 8 product launches are coming, and this should provide the next leg of growth for the technology giant. Shares should see a boost if sales are strong, but I wouldn't expect too much of a gain unless the P/E expands. Microsoft is fairly valued currently, and although there is upside, I don't see a tremendous amount of it. As a result, I've suggested a trade where you can increase your profits based on a stock that shouldn't move too much.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.