Microsoft's aQuantive Deal: An Act of Desperation

Undoubtedly, the biggest story the last week on Wall Street was Microsoft’s (MSFT) $6 Billion buy out offer of aQuantive (AQNT). This represented a close to 80% premium on the stock price and its price and volume soared. An exciting deal for aQuantive shareholders, but could it also be an act of desperation by Microsoft?

This nature of this deal and the discussion around it encouraged me to look deeper into the numbers and the motivations for this monster buyout. Microsoft certainly did not get aQuantive on the cheap – paying close to 80 times the Internet advertising agency's trailing 12 months levered free cash flow.

Furthermore, aQuantive was not struggling either, with its shares up 40% year-to-date before the buy out offer.

The extraordinarily high valuation of this deal prompted me to ask myself the following two questions:

1. Why would Microsoft pay too much?
2. What does this indicate for the rest of the landscape and the entire market as a whole?

For #1, part of the reason is fairly obvious. Microsoft has the money in the bank and produces huge amounts of cash, so the deal was certainly affordable for the company and shareholders. To look for more of the subjective reasons, we have to look at aQuantive’s 3 primary lines of business:

Avenue A / Razorfish – digital media and online interactive advertising agency, that designs creative and develops digital media and marketing strategies for companies.

Drive PM – a performance based marketing arm that aids in the resale of ad inventory and helping advertisers market their product/service only paying for results.

Atlas – aQuantive’s ad serving technology enabling distribution of web media and advertising, such as banner ads and video/rich media ads.

Microsoft has always been a company that develops and markets software and technology, not services. The first two business units above are service based businesses. In the case of Avenue A / Razorfish, you pay a service fee for them to design your web site, build an nice looking email, conduct a usability study, or help develop an Internet marketing strategy. In the case of Drive PM, as the advertiser/client, you specify how much you are willing to pay for web advertising, whether it be you are paying for eyeballs (impressions) or orders/sign-ups (like a sales commissions). DrivePM earns a transaction fee on this revenue as they have to share the revenue generated with their publishers and network.

I do not believe Microsoft was interested in these two aspects of aQuantive as much as they were in the Atlas technology. Historically, let’s remember that Avenue A / Razorfish used to be its own company that traded on the NASDAQ and really became acquired via a fire sale. DrivePM’s performance based network is far less effective than its rival Commission Junction which is owned by ValueClick (VCLK).

Atlas is a technology platform that enables advertisers and web site owners to deliver media and advertising content to web site visitors. From banner ads, to video ads, to search engine marketing, the Atlas platform does it all – and most importantly, it is a software/technology, Microsoft’s specialty. This insight should not be surprising considering that historically, Microsoft has acquired many companies that owned rights to software and then took that newly acquired intellectual property and successfully used it.

For the past few years, despite producing tons of cash, Microsoft has struggled to find identity in the new Internet powered marketplace. Its software, of course, remains a fixture on nearly all computers in every office in the world, but it is primarily desktop based. The company’s stock has done very well, relatively speaking, but is showing signs of slowing down and becoming expensive, even for having no debt and close to 40% return on equity.

Short and simple, Microsoft needs an answer to expand their business and find new avenues for growth, especially as we are seeing software go web-based. Note companies like Salesforce.com (CRM) that have done exorbitantly well marketing a web-based customer relationship management tool. There is no software to install on the server, just sign up online using a credit card and you can start using it right away. Intuit (INTU) has QuickBooks Online and Oracle (ORCL). Closer to home, for webmasters and people that work on web sites, we have seen FrontPage, one of their more popular products, become less and less useful as web-based tools to easily edit and design web pages have become available. Microsoft’s recent launch of Vista was exciting, but did not create the midnight stir that new movie debuts or the September release of the Halo 3 video game will create.

Microsoft is aware of these challenges and threats – and it has made no secret how much it is counting on its portal to become a bigger and bigger player out in the Internet eyeball marketplace. Although MSN has enjoyed success, it has continued to lag behind Google (GOOG) and Yahoo! (YHOO). Google has continued to thrive and has made some very major acquisitions to feed their future strategy and although Yahoo is not 100% keeping pace, it is their business and they are executing.

Microsoft needs the technology to allow it to deliver content, advertising, and media to its captive eyeballs. It doesn't own it and doesn't have the time to build it. Without aQuantive, Microsoft has no way to deliver video content to its users, as Google can with YouTube. More importantly, I believe, is the online gaming atmosphere. There are huge numbers of eyeballs that advertisers have been trying to monetize. Google recently bought AdScape and is working on a patent for delivering ads to gamers.

These two huge markets represent the threat to Microsoft and the subsequent desperation by the big software giant to get in the game as Microsoft does not have the technology to deliver, track, and generate revenue via these avenues. Even worse, without this ability, Microsoft risks Google (GOOG) coming in and cutting a distribution deal, as it did with MySpace. Imagine Google-powered content appearing in the XBOX online game interface? That is what scared Microsoft and prompted it to make a huge offer to lock-in the technology and prevent that disaster and prevent it from missing on that set of eyeballs and revenue.

By current numbers and estimates, it will take Microsoft close to 15-30 years to recoup its $6B investment in aQuantive. Of course, Microsoft will easily be able to reproduce the cash through existing operations, but this line-item will be in the red for sometime. It was either get in the game and wait at least a decade before seeing a payout or miss the boat and watch its competition widen the gap, perhaps to levels that are insurmountable. Microsoft is vying to be the top player in the space, perhaps by outsmarting or outlasting Google, perhaps by even buying them or (Yahoo! is more likely, if either deal happens).

I personally think that aQuantive management sold Microsoft a bill of goods in terms of value, but I think Microsoft knows that. This really is a last gasp attempt to stay in the game, which they are currently losing ground. This deal will not put Microsoft out of business by any means, but the end-result of this venture will help determine the future of the company's direction.

Congratulations to aQuantive longs and management - capitalism at its best. To borrow a line from Wall Street: "the illusion has become real - and the more real it becomes, the more desperately they want it."

Comments

[jbs:]

Your 15-30 years estimate is based on AQNT's earnings as a standalone company. It is not going to be operated as a standalone company, so the 15-30 year estimate is entirely misleading.

To an outsider it is hard to understand all of the benefits MSFT will gain from this acquisition. You'd have to know more about the various operating divisions at MSFT and their plans for integration.

MSFT is betting that they can add value - that AQNT as part of MSFT will benefit both companies. You must also look at the opportunity cost. There is no doubt that MSFT paid some sort of a premium to prevent someone else from buying AQNT (and posing a threat to MSFT down the line). MSFT may have also determined that it would have cost them more than $6B to develop an in-house solution. Many factors are considered in the acquisition process.

Just because MSFT values AQNT at an 80% premium to "the market" doesn't mean that they overpaid. AQNT may be worth $6B to Microsoft. If MSFT didn't acquire AQNT, they may have ended up foregoing $6B of income over the next 10 years (because without AQNT it could be argued that they would never effectively enter the market).

Time will tell, of course, but to say MSFT "paid too much" only days after the acquisition and without complete understanding of MSFT's plans for AQNT is premature.

2007 May 21 05:32 PM

[tchannon:]

Jordan - thank you for your comment. You are absolutely right - this really is more of a 1+1=3 acquisition than MSFT looking to incrementally add to the bottom line. Financially, MSFT can take it - even if AQNT goes to 0, the $6B is a small amt of MSFT's cash and they will make that up quickly via operations.

And, yes, 100% agreed that I am not privvy to the exact discussions that took place between MSFT and AQNT and saying it is 'too expensive' the day after could certainly be premature.

MSFT has yet to succeed they can compete with Google or Yahoo! on the Internet level and the world is certainly moving towards a more web-based rather than desktop-based environment. MSFT, I believe, acted more out of fear than definitive certainty that this deal will pan out. Only time will tell. I think financially the premium is way too high and will put pressure on MSFT's line items over the coming years, though not to the point of materially damaging their business - more like someone's spreadsheet will be hurting. In many ways, MSFT had no choice, it seems and the act was motivated out of a fear of missing out rather than a definitive business plan. I also believe VCLK would represent a better choice over AQNT due to my personal experience with working with both companies. I would imagine or surmise that MSFT and VCLK had discussions as well and in the end AQNT said what MSFT wanted/needed/was looking to hear and that is what closed the deal.

In the end, these forums are just a place to express opinions and create dialogue and I appreciate your feedback and you do make valid points.

2007 May 23 08:58 PM