Wednesday, September 29, 2010

Establish Microsoft Corp. Covered Calls

A new covered calls position was established in the Covered Calls Advisor Portfolio(CCAP) with the purchase of Microsoft Corp.(MSFT) covered calls as follows:

Established Microsoft Corp.(MSFT) Covered Calls for Nov2010:
09/29/2010 Bought 500 MSFT @ $24.43
09/29/2010 Sold 5 MSFT Nov2010 $25.00 Calls @ $.76
Soon after today's market open, MSFT was trading at about 1.0% below yesterday's close, and the Covered Calls Advisor took that opportunity to purchase the MSFT shares. About 4 hours later, when the price of MSFT had risen to $24.60, the Covered Calls Advisor legged-in to this covered calls position by selling the Nov2010 $25.00 call options at $.76.

This position doubles the current holdings in the CCAP from 500 to 1,000 shares. Despite the fact that the Covered Calls Advisor almost always establishes near-month covered calls positions, in this instance the second available expiration month (Nov2010) was selected to:
(1) take advantage of the higher implied volatility in the Nov2010 options (compared with that of the Oct2010 expiration). This is the case primarily because the next quarterly earnings report is scheduled for release after Oct2010 expiration but prior to Nov2010 expiration, and the added uncertainty is reflected in the expanded options premiums available for Nov2010 expiration. As described below, this advisor is reasonably confident that Microsoft will meet or exceed analysts' expectations (Also note: MSFT has exceeded earnings per share expectations in each of the last 4 reporting quarters); and (2) Dividend Capture: Microsoft recently raised their quarterly dividend by 23% to $.16 and they will go ex-dividend on Nov. 16th, which is three days prior to the Nov2010 options expiration.

These transactions now complete the establishing of covered calls positions prior to Oct2010 expiration. The Covered Calls Advisor Portfolio is now 94 percent invested in covered calls and is 6% in cash. The cash position is available for rolling up an existing position (at a net debit if necessary) if the appropriate circumstance should arise to do so.

Microsoft is the world's largest software maker, primarily as a result of its near monopoly position in desktop operating systems and its Office productivity suite. The combination of these two strongholds poses a formidable barrier to entry for competitors. The new product-cycle offerings in these two areas (Windows 7 and Office/Outlook 2010) are being well received and will provide nice growth catalysts for at least the next two years. Moreover, Microsoft has used its strong cash flows from these businesses to fund research and development in other markets, including home entertainment consoles and internet online advertising.

The company has five operating business divisions: Windows and Windows Live, Server and Tools, Online Services Business, Microsoft Business, and Entertainment and Devices. In the most recent quarterly earnings report, each of their five divisions showed double-digit revenue growth while also keeping operating costs below expectations. Based on these results, this advisor believes that Microsoft continues to successfully streamline its cost structure, which will allow the company to show significant operating margin and earnings per share leverage. The Windows division includes the Windows operating system cluster of products, the Server and Tools division includes the Windows Server operating system and enterprise oriented products, the Online Services Business includes web-based advertising, MSN and the Bing search engine, the Microsoft Business Division includes the MS Office suite of products, and, finally, the Entertainment and Devices division features the Xbox 360 game console, video games such as 'Halo 3,' and software for mobile and embedded devices. Microsoft has about 93,000 employees worldwide and is based in Redmond, Washington.

Looking to the near-term future, the company should continue to benefit from the robust consumer demand for PCs, and improved business demand for PCs and servers. The company is poised to benefit substantially from the overlapping Windows 7, Windows Server, Xbox Kinect (Their new hands-free interface for the Xbox 360 game console that will be available before Christmas this year), Azure (Cloud Computing), Bing (Search), SharePoint (Web development for businesses), and Microsoft Office/Outlook 2010 new-product cycles during the second half of calendar year 2010 and into 2011. It appears to this advisor that Microsoft's impressive offerings in this product cycle are under-appreciated by both analysts and investors.

Analysts' current earnings estimates of $2.38 per share for FY 2011 (Note: Microsoft's FY 2011 ends on June 30, 2011) seem to understate Microsoft's earnings potential, which this advisor estimates will exceed $2.50. So a stock price catalyst in the form of several upcoming beat-and-raise quarterly reports is likely. Placing a historically conservative P/E of 12 on $2.50 earnings plus over $4.00 per share of net cash results in a $34 target price (a 35% increase above its current price). In short, given Microsoft's improving outlook, the stock is now cheap since it is trading near the bottom of its ten-year historical range on both a price-to-earnings (P/E) and an enterprise value-to-sales (EV/Sales) basis, thus providing room for some expansion in these multiples in the coming months.

Finally, in addition to its attractive financial valuation, Microsoft is also an attractive investment because of its shareholder-friendly capital allocation policies (buybacks & dividends). Microsoft recently completed a $4.75 billion bond offering at extremely low interest rates, thus demonstrating not only their financial strength in the marketplace, but also (and more importantly in this advisor's opinion) their financial savvy. Given the already high cash level on their balance sheet and their terrific ongoing cash flow, there is substantial cause to wonder about the possibility of a large acquisition [Perhaps RIMM? or SAP? or Yahoo?(again!)].

Most importantly for this advisor, the Buy Alerts spreadsheet below (includes financials through the 2010 fiscal 4th quarter) shows that MSFT is a very attractive at this time since the total points rating of 18.12 is well above the Covered Calls Advisor's "Buy" threshold of 16.0.

Note: For expanded view, left click on the spreadsheet above.

Some possible overall performance results(including commissions) for the Microsoft Corp.(MSFT) transactions would be as follows:
Stock Purchase Cost: $12,223.95
= ($24.43*500+$8.95 commission)

Net Profit:
(a) Options Income: +$367.30
= (500*$.76 - $12.70 commissions)
(b) Dividend Income: +$80.00 =($.16 * 500 shares)
(c) Capital Appreciation (If stock price unchanged at $24.43):
-$8.95 = ($24.43-$24.43)*500 - $8.95 commissions
(c) Capital Appreciation (If assigned at $25.00): +$276.05
= ($25.00-$24.43)*500 - $8.95 commissions

Total Net Profit(If stock price unchanged at $24.43): +$438.35
= (+$367.30 +$80.00 -$8.95)
Total Net Profit(If stock price assigned at $25.00): +$723.35
= (+$367.30 +$80.00 +$276.05)

Absolute Return if Unchanged at $24.43: +3.6%
= +$438.35/$12,223.95
Annualized Return If Unchanged (ARIU) +25.2%
= (+$438.35/$12,223.95)*(365/52 days)

Absolute Return if Assigned at $25.00: +5.9%
= +$723.35/$12,223.95
Annualized Return If Assigned (ARIA): +41.5%
= (+$723.35/$12,223.95)*(365/52 days)

Downside Breakeven Price Point: $23.51 = [$24.43-($.76 option income +$.16 dividend)]
Downside Breakeven Protection: 3.8%