Microsoft Jumps 15% on Strong Free Cash Flow - What's the Best MSFT Play Now?

Microsoft Corp (MSFT) delivered strong results on Wednesday, July 29, and tempered fears about future capex and lower FCF. As a result, MSFT was up over 15% yesterday. So, is MSFT stock still undervalued, and what is the best MSFT play now? This article will discuss these issues.

MSFT closed at $451.10 on July 30, up 15.5% from $390.54 the day before. That's up from a recent closing low of $352.83 on June 25, but still below a June 1 6-month peak of $460.52.

However, based on analysts' revenue forecasts, its strong operating cash flow, and management capex guidance, its free cash flow (FCF) going forward could be worth over 16% more at $525 per share. Moreover, analysts have set their price targets even higher. Let's look into this.

Strong Cash Flow Generation

Not only did revenue rise 17.75% in its fiscal Q4, ending June 30, to $90 billion, but it was also up 17.8% YoY to $331.8 billion for its FY. Moreover, the WSJ reported that this included over $100 billion in Azure revenue, which it had not previously disclosed. That will allow analysts to compare this division's future growth with Amazon's AWS and Google Cloud revenue.

However, more importantly, its operating cash flow (OCF) in Q4 was $55.44 billion, representing an OCF margin of 61.6%. 

Here is why that is important. The fiscal Q4 61.4% was well over the trailing 12-month (TTM) OCF margin of 55.1% (i.e., $182.9b/$331.8 billion). This implies that, going forward, Microsoft can afford significantly higher capex, which is funded by operating cash flow.

Management said they now expect to have just $175 billion in capex this next fiscal year. That was lower than $190 billion previously forecast by analysts, according to the WSJ, due to an accounting change. As a result, we can forecast its FCF using this information.

Forecasting Microsoft FCF

For example, analysts are now projecting $390.1 billion in FY 2027 revenue (ending June 30, 2027) and $464.29 billion (ending June 30, 2028).

So, if Microsoft can generate an average 61.6% OCF margin, its FCF will be:

  $390.1b x 0.616 = $240.3 billion OCF - $175 billion capex = $65.3 billion FCF (yr ending 6/27)

  $464.3b x 0.616 = $268 billion OCF = - $190 billion (10% higher) = $78 billion (6/30/28)

In other words, over the next 12 months (by 12/31/27), its FCF should be about $71.7 billion.

That is despite having significantly higher capital expenditures. This could push its fair market value and price targets higher as well. Here's why.

Fair Market Value and Price Targets for MSFT

For example, assuming the market gives MSFT a 2.0% FCF yield (the same as multiplying FCF by 50x), its fair market value (FMV) will be: 

  $71.7b x 50 = $3,585 billion (i.e., $3.585 trillion) FMV

That is 7% higher than today's elevated market cap of $3.351 trillion (Yahoo! Finance). In other words, the next 12-month (NTM) price target (PT) is:

  $451.10 x 1.07 = $482.68 PT

However, by the end of 2027, analysts will be expecting $78 billion in FY 28 FCF. That could push the FMV to $3.9 trillion (i.e., $78b x 50), or +16.4% higher.

In other words, next year its PT will be $525 per share (451.10 x 1.164).

Analysts have even higher price targets. For example, the Yahoo! Finance analyst survey is now $555.77 per share (51 analysts). Barchart's mean survey PT is $544.31. Moreover, AnaChart's survey of 31 analysts is $564.83, or 25.2% higher.

The bottom line is that MSFT looks undervalued, both from a FCF standpoint and using analysts' price targets.

However, one conservative play, should MSFT drop after yesterday's large gains, is to sell short lower strike price puts.

Shorting Out-of-the-Money (OTM) MSFT Puts

I discussed this play in my last Barchart article on July 6, “Is Microsoft Stock Too Cheap Here? One Play is to Short Cash-Secured MSFT Puts.” I pointed out that shorting the $370 put strike price expiring Aug. 7 (i.e., 5% below MSFT's trading price of $390.16) would earn an investor a one-month yield of 2.914% (i.e., $10.78/$370.00).

Today, that strike price is down from $10.78 to just 12 cents. In other words, in just over 3 weeks (i.e., since July 6) and investor would have earned over 2.91% shorting these puts. It makes sense to repeat this play.

(Granted, existing MSFT investors would have more. That is why I always suggest investors use a short-put strategy only for stocks they believe are undervalued and already have a position.)

For example, the Sept. 4 expiry period shows that the $425.00 put strike price has a midpoint premium of $8.05. That can provide an investor a 1-month yield of 1.894%. Here's why.

After the investor secures $42,500 with their broker, they can enter a trade to “Sell to Open” 1 put at $425.00. The $42.5K acts as collateral in case MSFT drops 5% to that point and the account is assigned to buy 100 shares at $425.00.

Immediately, the account will receive $805.00, so the investment yields $805/$42,500 for the next month (i.e., 1.894%). If MSFT remains over $425.00 by Sept. 4, the collateral is released so the investor can repeat the play.

If this play can be repeated each month for 6 months, the expected return (ER) is 11.364%. That is the same as buying MSFT today and seeing it rise to $502.36.

Moreover, even if the account is assigned to buy 100 shares at $425.00, the breakeven price is $425.00 - $8.05, or $416.95. That is 7.6% lower than yesterday's close, and provides good upside:

  $525.00 PT / $416.95 breakeven  = +26% expected return

The bottom line is that MSFT looks cheap here, and one way to play it is to short out-of-the-money puts over the next month.