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Microsoft (NASDAQ:MSFT) announced yesterday that it is acquiring an enterprise social network company, Yammer, for $1.2 billion. According to Reuters, Yammer's 5 million users are valued at $240 each. Yammer, which was co-founded by former PayPal executive and CEO David O. Sacks, is the first company to tap into enterprise social networking. More than 85% of Fortune 500 employees now use Yammer to collaborate, share projects, and communicate amongst themselves in order to improve work efficiency. We believe that the acquisition of Yammer will help Microsoft capitalize on its large enterprise software distribution network, with the addition of Yammer's enterprise social network built into its products e.g. Microsoft Office.

Microsoft currently generates approximately 60% of its revenue from MS Office Suite, which is considered vital in the daily activities of a large number of businesses worldwide. The Yammer acquisition is expected to fill an essential social networking feature gap in Microsoft SharePoint, which is a part of the Office Suite offered by Microsoft.

Today, companies have started realizing the power of social media networking in our everyday lives. Enterprise social networking is still at a nascent stage, but tech companies, such as International Business Machines Corp. (NYSE:IBM), SalesForce.com (NYSE:CRM) and Oracle Corp. (NYSE:ORCL), have started investing in this sector to provide enterprise social networking services built within their own enterprise applications. SalesForce.com's recent acquisition of Buddy Media Inc. for $745 million, and Oracle's announcement to acquire two social media data analysis companies, are two examples of software providers' growing interest in enterprise social networking. Cisco (NASDAQ:CSCO) and IBM have also been reported to be looking to introduce enterprise social networks. IBM has announced "Connections" and Cisco has launched "WebEx Social" in this regard. SalesForce.com's product "Chatter" and Jive Software (NASDAQ:JIVE) are also noted players in enterprise social networking.

Yammer operates on a subscription-based business model with paid subscriptions providing extra security and integration features compared to free subscriptions. Approximately 1/5th of Yammer's current 5 million users are paid subscribers.

LinkedIn (NYSE:LNKD) may also have been testing an internal enterprise social network to facilitate communication among LinkedIn employees. It may launch a similar service in the future to take advantage of its large corporate user base. Furthermore, continued interest in enterprise social networking services may spur interest in acquisition of small companies like Jive Software and Telligent.

Yammer raised $85 million in February 2012, based on a valuation of $600 million, compared to Microsoft's cash price of $1.2 billion. Yammer does look an expensive buy for Microsoft, but the synergies it can generate after integration with Microsoft SharePoint may prove it to be sensible.

Microsoft's SharePoint is an integral part of Microsoft Office's enterprise software application suite, and enables people to share, manage and work together on projects. Previously, Microsoft SharePoint had been lacking advanced social networking features that are currently available in Yammer. Now, through the acquisition of Yammer, Microsoft is expected to integrate Yammer in SharePoint, thereby improving the overall quality of the application, and boosting brand loyalty and equity among users. Yammer's services are also expected to help Microsoft in expanding its cloud-based enterprise services to end consumers. Furthermore, Microsoft, through its enterprise software applications e.g. MS Office, is now expected to compete equally with IBM and Oracle, who provide enterprise social networking services already built into their software suites.

Precise integration of Yammer's services will make Microsoft's enterprise applications more social, allowing the latter to take advantage of Yammer's existing popularity among corporate users. It is worthwhile to note that building a social network, which becomes popular among users, is not an easy task. Enormous social switching costs are associated with switching to new social networks in the form of a lack of contacts on the new network, and the difficulties associated with understanding the whole new interface and features. Therefore, acquiring an existing popular social network sounds logical compared with building one internally.

Additionally, last year's acquisition of Skype, which cost $8 billion, can allow Microsoft to integrate Skype services with Yammer, both within SharePoint; thus improving the overall user experience relating to audio/video conferencing services. In addition, resource-rich Microsoft provides Yammer with a bright opportunity to expand geographically.

Therefore, we believe that the recent acquisition of Yammer will definitely prove to be worthwhile for Microsoft. However, Microsoft may face challenges related to the user monetization and seamless integration of Yammer services in its software applications.

Microsoft shares closed at $29.86 yesterday, after falling 2.72% in intraday trading. The stock has risen 15% since the start of this year. MSFT is currently trading at 9.7x times forward earnings, and we consider it cheap. We believe that the recent announcement of Windows Phone 8, Windows Surface Tablet, and now the acquisition of Yammer will speed up growth for MSFT. Therefore, we expect the stock to trade at a higher multiple in the range of 12x-15x after keeping in view the historical upsides. The new element of social media should improve the valuations of MSFT, as Facebook (NASDAQ:FB) and LinkedIn (LNKD) are currently trading at 47x and 84x forward earnings, respectively.

Have a look at our articles analyzing Microsoft s entry into the tablet market and Windows Phone 8 OS.

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

Source: Microsoft's Entry Into The Enterprise Social Networking Market