Microsoft's Next Move Could Earn You +1,900%

Andy Obermueller's picture

Tuesday, February 17, 2009 - 2:28pm

by Andy Obermueller

Microsoft (Nasdaq: MSFT) said Friday it had hired a veteran Wal-Mart executive, David Porter, to oversee the development of brick-and-mortar retail stores. He will report to Kevin Turner, Microsoft's COO, who also has ties to Bentonville.  

 Apple (Nasdaq: AAPL) changed computer marketing with its hip advertising. It changed the computer market with its nifty devices, and it changed the computer marketplace with its stores. Microsoft sees the writing on the wall, and these hires underscore how serious Microsoft is about regaining any of the ground it has lost to Apple. Porter and Turner aren't show horses -- they're work horses. Wal-Mart executives get things done fast and cheap, and they never lose focus on the customer. That core competency will be vital to Microsoft's retail execution. Here are four reasons I think Porter's first step will be to engineer a merger with software retailer GameStop (NYSE: GME).

1. Microsoft Is Always on the Hunt for Deals
Though the ill-fated Yahoo merger is the most well known, Microsoft has put its vast cash hoard to work by acquiring companies that have something it needs. Over the past two years, MSFT's shopping cart has been loaded with search, voice and advertising technology. Certainly Microsoft has the human capital to develop new technologies on its own, but it's cheaper -- and far faster -- to simply buy it. The same is true with its stores.

And the fact is, Microsoft can quite literally buy anything it wants. The Redmond company is one of seven U.S. corporations to have a triple-A credit rating. It has cash on hand totaling $8.3 billion, and it has no long-term debt.

2. GameStop Has a Huge Footprint
GameStop has an international presence that includes 5,264 stores. GameStop's stores tend to be in urban areas, in shopping centers and strip malls. These aren't destination stores like Wal-Mart; they are located where people already eat, shop and work. This is precisely where Microsoft will seek to extend its reach and build its brand. A GameStop deal would give Microsoft an instant competitive advantage over Apple, which has only 250 stores. Many of GameStop locations are near existing Apple stores. 

3. GameStop Is Cheap
GME is trading for only 12 times earnings. As the chart shows, that's near the ebb. GME's two-year average earnings multiple is 27.

Though a dramatically reduced P/E usually signals concerns about future earnings, GameStop doesn't have that worry.

Sales continue to be brisk. It even did well during the holidays, posting sales increases most retailers would have killed for. GameStop's EPS has never declined, and even in the current economic climate, earnings are forecast to rise.

4. GameStop Stores Meet Microsoft's Needs
GME's relatively small stores -- already clean and well-lit -- are ideal for Microsoft. They're less than crowded and could easily make room for Microsoft products, display kiosks and demonstration models. Maximizing store efficiency is something that Porter and Turner learned at Wal-Mart, which tracks revenue by square inch of shelf space. What's more, GameStop existing staff would gel nicely. They tend to be avid computer users, fluent in the lingo and up on the latest products. 

GameStop Will be Acquired at a Premium
The vast majority of these shares are held by institutions, who have held on through GME's -46% decline in the past year and are unlikely to approve a merger that doesn't help make them whole, especially from a company that absolutely can afford to pay. GME's current market capitalization is roughly $4.3 billion. Microsoft would be getting a steal at $10 billion -- the footprint it wants and a business that produces tons of cash without any debt and doesn't have to burn cash to develop products. An acquisition at $45 a share would represent a +70% premium and still value the company at less than its historical valuation.

Think that's too rich of a premium for GameStop? Consider: Microsoft offered $31 a share for Yahoo last year when its shares were trading at $19.18. Yahoo rejected the +61.6% premium as too low, and after one of the strangest negotiations in corporate history, Microsoft raised its offer to $33 -- +72% over Yahoo's pre-merger offer price.

A Microsoft-GameStop deal makes sense financially for GME, MSFT and investors. It achieves overnight a footprint that otherwise would take years to build. And it marries two compatible cultures: Apple users aren't gamers, but Windows users are.

Here are the two ways you can play this, depending on your risk tolerance:

1. Go Long  
Buy GameStop and hope for a takeover announcement that includes a rich premium.

The upside: It happens and the stock skyrockets to the takeover price. 

The downside: The merger doesn't go through. What then? Well, it's not exactly bleak! All that happens is you will own shares of a successful earnings machine that you bought cheap yet is continuing to post ever-improving results.

2. Position Yourself for Huge Gains with Call Options
A Call Option gives an investor the right to buy a stock for a certain price during a certain time. A July 30 GME call would allow its holder to buy GameStop for $30 a share until July 18. If the price goes above that, the call will gain in value. It can be sold to capture the gain, or it can be exercised to buy the stock, which could then be resold for a gain.

So assuming an investor were willing to bet on a $45 takeover price, then an out-of-the-money call might suit his fancy. Here are Friday's prices of GameStop calls with a $30 strike price: 

Expiration Price 100 Shares Downside Gain at $45
21 March $0.90 $90.00 $90.00 +1,900%
21 April $1.70 $170.00 $170.00 +782%
18 July $2.90 $290.00 $290.00 +417%

As you can see, the upside is phenomenal and the downside is modest. The question, of course, is timing. If the deal doesn't go through, the only chance you have of coming out ahead is a +15% rally in GameStop shares for an unrelated reason.

Is that possible? Sure. So is a merger. As to the degree of likelihood and to whether it's a good investment for you depends entirely on your risk profile.

Andy Obermueller does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.