Microsoft May Grind To Record Highs

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About: Microsoft Corporation (MSFT)
by: Mott Capital Management
Summary

Microsoft's options suggest volatility will remain low.

The options also suggest the stock rises over the next month.

The technical chart is bullish as well.

Microsoft (MSFT) weathered the recent stock market sell-off very well, falling 5.3% in May. That was better than the S&P 500 drop of 6.6% and the NASDAQ's decline of almost 8%. Now Microsoft is rising, and based on options betting, the stock may still have further to climb.

The last time I wrote on Microsoft was on May 1, which proved to be bad timing on my part. That was when trade tensions and interest rates worries sent the equity market into a tailspin, resulting in the stock falling and not rising as I had thought. You can now track my success and failure rate from these articles on this Google Spreadsheet I created.

Low Levels of Volatility Expected

The options market is not pricing in a heightened level of volatility for the stock over the next month. Using the long straddle strategy, the options for expiration on July 19 imply the stock will rise or fall 6% from the $135 strike price. It places the stock in a trading range of $126.80 to $143.20 by the expiration date.

Betting on an Increase

The low level of volatility may allow the stock to continue to grind higher over the coming weeks, at least that is what the options suggest. The options for expiration on July 19 have seen an increasing level of open interest in recent days. The open interest levels for the $140 calls have risen to around 14,000 contracts. A buyer of the calls would need the stock to rise to around $141.60, an increase of about 6.5% from the stock's current price of approximately $133 on June 11.

Technical Continuation

The chart also shows the stock breaking out of a symmetrical triangle, which suggests the shares could rise to around $140.50. The triangle is a continuation pattern from the equity's previous advance when it rose off the December lows. The relative strength index is also trending higher, suggesting that bullish momentum is moving into the stock. The RSI has also broken its recent downtrend, indicating a change in trend.

Strong Fundamentals

The company will report its fiscal fourth-quarter results in July, and analysts are estimating that earnings will grow 7.1% to $1.21 per share, on revenue growth of 8.9% to $32.76 billion. But more importantly, the year will roll over and that will help to bring down the company's PE ratio. That's because we can value Microsoft on a one-year forward PE using the fiscal year 2021, instead of 2020.

Currently, the stock trades at roughly 23 times 2021 earnings estimates, not a high level when compared to some of its other software and cloud provider peers, Amazon (AMZN) and Adobe (ADBE)

One thing going in Microsoft's favor is that analysts are looking for revenue growth to remain constant around 11% per year in 2020 and 2021. Meanwhile, earnings growth is expected to accelerate to 15.3% in 2021 from 11.3% in 2020.

Additionally, analysts see the stock rising in the future as well. The average analysts' price target on the stock is around $142.85, nearly 8% higher than the stock's current price.

Chart Data by YCharts

RISKS

The market has been extremely volatile, and like last month, there is always the chance that my timing is once again bad. With the G20 summit approaching at the end of June, negative headlines around China or trade could easily drag the technology sector lower. Microsoft is a big component in the sector and represents a 20% weighting in the Technology Select Sector SPDR ETF (XLK). It means that if technology sells off again, it will be hard for Microsoft to avoid getting caught in the downdraft.

Additionally, the PE chart above does suggest that the stock isn't cheap when compared to its historical valuation. Previously, the stock's PE ratio topped out around 22 times. For the stock to continue to rise, it will need further multiple expansion, and that means the company will need to not only meet its earnings estimates but beat them by a wide margin.

The momentum in Microsoft is there for the stock to continue to rise. As long as the stock market doesn't get sidetracked again, there is a good chance this stock continues to grind higher.

Disclosure: I am/we are long MSFT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Mott Capital Management, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Upon request, the advisor will provide a list of all recommendations made during the past twelve months. Past performance is not indicative of future results.