A Cheap Strategy to Play at Microsoft

Bill Gates is very rich, but his once very successful software company has been on a downward slide since mid-2002, from the $35 level. The problem with Microsoft (MSFT) has been the company’s inability to grow both revenues and earnings at the superior rates it once enjoyed.

Any company the size of Microsoft, with a market capitalization of $242 billion, would see growth as a problem because of its size. But that doesn’t mean the stock is dead. On the contrary, Microsoft remains a viable software company for the long term and is cash rich with $34 billion or $3.28 per share in cash. This gives the stock plenty of financial flexibility to develop or acquire growth technologies. Microsoft announced that it will spend $1.1 billion on R&D at its MSN Internet unit in fiscal 2007. According to the Wall Street Journal, Microsoft is exploring the possibility of taking a stake in Internet media company Yahoo (YHOO) to counter Internet advertising giant Google (GOOG).

But the company, with an estimated five-year earnings growth rate of 12%, has its work cut out for it. Trading at 16.30 times its estimated FY07 EPS of $1.44, the stock isn’t expensive but doesn’t appear to be priced as a growth stock.

On the surface, its PEG of 1.51 is not cheap, but discounting cash of $3.28 per share, the estimated PEG falls to around 1.0, which is a good valuation. Moreover, if Microsoft can increase its estimated growth rate of 12%, the PEG would fall even further.

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The truth is that Microsoft deserves a look at its current price. If you want to play the stock but don’t want to shell out $2,347 for a block of 100 shares, you might want to take a look at long-term options, also known as LEAPS. For example, the January 2008 $22.50 Microsoft Call LEAPS, which don’t expire until January 18, 2008, currently cost $380 per contract (100 shares).

This means that you are risking a total of $380 for the chance to participate in the potential upside of 100 shares of Microsoft over the next 20 months. The breakeven price is $26.30. If Microsoft breaks $26.30, you start monetizing your LEAPS. Conversely, if Microsoft does nothing, your maximum risk in the first options play is $380.

Warning: The example above is for illustrative purposes only and should not be construed as a real options strategy. Due to the high risk inherent in options, I recommend that you speak with an investment professional before deciding to use any strategy involving options.