The Barnes & Noble/Microsoft Deal: What's In It For Microsoft?

May. 8.12 | About: Microsoft Corporation (MSFT)

On Monday, April 30, Microsoft (NASDAQ:MSFT), the world's leading software company, announced a $300 million joint partnership with Barnes & Noble (NYSE: BKS), much to the surprise of the market and the utter delight of Barnes & Noble shareholders, who promptly saw a better than 60% gain in their holdings. This was the stock's greatest gain since its IPO in 1993.

It's easy to see the advantages for Barnes & Noble: Influx of capital into a deeply-indebted company and an alliance with the deep-pocketed and influential technology giant. But what's in the deal for Microsoft?

First, the rundown on the partnership. Microsoft will help Barnes & Noble to spin off its digital and college businesses into a separate entity at a future date, in which Microsoft will hold a 17.6% stake. In return, Microsoft will include a Nook application in its release of Windows 8, which is expected to occur later in 2012. This will place the new company in direct competition with Amazon (NASDAQ:AMZN), Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOG), whose own tablet offering is frequently rumored.

Currently Microsoft has approximately zero percent of the e-reader and tablet market. This tiny investment in Barnes & Noble will catapult it straight into a competitive position. The Amazon Kindle is nearly synonymous with "e-reader" and commands a 60% share of the market, but the Nook holds a respectable 2nd place with 27%. In terms of the tablet market, however, both devices together cannot hold a candle to Apple, with its iPad dominating the segment with 68% market share. There is certainly the possibility for a sub-category in the tablet market, at a lower price point than the iPad, and this deal may make the Nook competitive enough to duke it out with the Kindle Fire for leader of that market. Currently in the Android-based tablet market, Samsung holds leadership position with its Galaxy Tab, with the Kindle in 2nd place, Lenovo in 3rd, and Barnes & Noble lags behind at 4th.

It is probable that Microsoft will drive the Nook toward using the Windows 8 operating system instead of Google's Android OS, and this would likely happen sooner rather than later. Microsoft needs a tablet of its own, as consumers switch away from PCs and into mobile devices. But the company has had its difficulties in the consumer electronics market. Is the Nook fated to become the e-reader equivalent of the Zune, Microsoft's failed attempt to compete in the MP3-player market against Apple's iPod? Yes, the cost of entry was low for Microsoft, but can the Nook really contribute to Microsoft's future when it can barely keep its parent alive?

Aside from the Barnes & Noble deal, Microsoft has a solid balance sheet, loads of cash for further acquisitions and partnerships, and decent growth potential. Earnings for FY2011 were $2.69, are expected to be $2.71 for FY2012 (OK, not much growth this year), and are predicted to be $3.04 for FY2013. That corresponds to a 13% potential gain by the end of 2013. Microsoft's current P/E multiple is 11.6 compared with the industry average of 17.6. It is underpriced as well against its peers in both Price-Sales and Price-Book measures. Additionally, Microsoft pays a higher dividend than its rivals. Microsoft's debt-equity ratio is lower than the industry, its gross and net margins beat the industry, and its 5-year return on investment is 70% higher.

Analyst opinion is favorable, with 12 Strong Buy recommendations, 11 Buys, 11 Holds, and only 1 Sell. The mean target price assigned is approximately $36. Microsoft is currently trading at about $31, not far from its 52-week high at $32.95. While not offering a tremendous amount of upside, it does seem like minimal downside risk.

Other recent news for Microsoft includes its rollout of the $99 Xbox bundled with 2 years of Xbox Live Gold membership, and the fact that Stifel Nicolaus placed a $38 price target and a Buy recommendation on the company.

Personally, I really appreciate the fact that Microsoft has made this deal. It will offer competition to prevent Amazon from becoming a monopoly in the e-reader market, and hopefully it will also enable the Nook to rise to compete in the tablet market against Apple. It has a long way to go in both markets, however. And the e-reader market, where the Nook strength lies, is likely to decline in the not-too-distant future as consumers turn to more versatile tablets.

Granted, Microsoft has bought into the profitable digital and college businesses of Barnes & Noble, and has avoided the money-losing retail business. Investors from both companies will be waiting anxiously for further details of the new entity and how it will affect the market. Little mention has been made of the college bookstore business, which is profitable, but at the same time one wonders just how long physical textbooks (and their astronomical prices) can survive in this cost-competitive and increasingly-digital world. College students will likely be embracing the move to e-books even more rapidly than the general public.

If you will, buy Microsoft for its own merits, not because of this deal. I am sure that the powers-that-be at Microsoft are not helping out Barnes & Noble purely from the goodness of their hearts; expect that this partnership will be beneficial to Microsoft, possibly in some unforeseen way. But I just don't see Barnes & Noble adding greatly to Microsoft's bottom line at this time.

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