Microsoft Should Listen to Its Heart (and ignore the bean counters)

Microsoft (MSFT) surprised no one with its unsolicited offer for Yahoo! (YHOO) in January 2008. What surprised some Wall Street observers was the premium Microsoft was willing to pay for Yahoo's then share price. At that time the $31/share offer represented a 62% premium over Yahoo's then share price of $19.18. What surprised the same observers was that, even that premium was not enough to sway Yahoo's board in Microsoft's favor. It will help to take a step back and put the offer in its historical context to understand the action of different players.

Yahoo's History: Massive Fortune Swings

Long term Yahoo stock holders are no stranger to massive swings in its stock price. As one of the pioneers of the internet age, Yahoo's legacy is enshrined in history.

One of the first darlings of the internet, it saw its stock price rise to stratospheric heights of $120+ at the peak of the .com bubble only to collapse to less than $5 in 2001. Since then the stock has recovered, reaching a high of $40+ in 2006, and traded as high as $34 last fall. The stock price fell significantly over the past six months as the Nasdaq sold off on the fear of an economic slowdown. Further, Google's (GOOG) continued dominance and the failure of Yahoo's internal initiative created further downside.

According to Alexa, the most popular web-sites in the world are: yahoo.com, google.com, youtube.com, www.live.com (Windows Live), and msn.com. Based on Microsoft's earnings reports, its online division is still not profitable even though they have the #4 and #5 web-sites in the world. Yahoo on the other hand, strongly lags Google when it comes to monetizing its traffic.

Yahoo's Future: Is Growth Possible?

Yahoo detractors believe that the inability of Yahoo to monetize the eye-balls shows that it should not continue as an independent company and share-holders should accept Microsoft's generous offer. The Yahoo supporters believe once Yahoo starts taking more drastic actions, including strategic partnerships with other firms, it will be quite easy to monetize the traffic and boost the share price. The online revenue model is highly levered and once the fixed costs are accounted for, a bulk of the revenue after the cost of sales falls to the bottom line. A 15% increase in average monetization per visitor, can almost double Yahoo's earnings.

The View from the Valley

Silicon Valley and Microsoft have had a strained relationship over the past two decades. Valley entrepreneurs believe that Microsoft stifles innovation and growth by using the massive size of its installed base steam-rolling any competition. The valley is littered with companies who were destroyed by the Microsoft Borg.

As one of the brightest, though fading, beacon of Silicon Valley, selling out to Microsoft is not any task for Yahoo to swallow. Microsoft was always the evil empire, and going over to the dark-side does not appeal to a lot of Yahoo workers, many of whom are reasonably wealthy after reaping their stock option rewards.

Jerry Yang seriously believes that selling out to Microsoft at the current price would be morally wrong. As the CEO he has the right (or perhaps even the duty) to believe that Yahoo's fortunes will become better; so a sell-out has to be at a price which justifies selling out.

Yahoo has friends in the valley. Both Google and Yahoo were spun out of Stanford and Yahoo had invested in Google. Yahoo can and will tie up with Google, if that is what it takes to make things work. The fact that a simple ad-serving trial got Microsoft to rush to the speed-dial to the Department of Justice, means that Microsoft realizes that too.

Microsoft's offer came at a time when Yahoo's stock had lost more than 40% of its value in a few months. It was timed and priced at a point to allay the fears of major institutional stock holders who had seen their asset values plummet. However for Yahoo, it was adding insult to the injury. The offer was still 10% less than what Yahoo was trading a few months before.

The View from Redmond

Financial: Isn't 61% Enough?

From a financial point of view, Microsoft is correct in believing that a 61% premium over Yahoo's price before the offer is a rich enough premium. Many Wall Street pundits are banging the desks and saying that there is no point for Microsoft to compete against itself. Yahoo does not have any other suitor and the shareholders do not have any other option but to accept Microsoft's offer.

However, what they miss is that Yahoo is a reluctant bride at best. It is also a proud company, secure about its legacy. Though the recent share-holders may not like it, the rank and file do not mind short term swings in stock price as long as they believe in the long term vision (lower short term prices mean cheaper stock options for the employees). And in spite of the missteps of the past few years, Yahoo continues to be the #1 site on the web. A few correct moves and they will be boogying in Sunnyvale.

Strategic: OMG!

With each passing day Redmond is realizing that Microsoft has the risk of becoming increasingly irrelevant. The last quarter's earnings report showed that all its business units except for the one which makes the Xbox underperformed. Microsoft lowered it's near term guidance, though it guided up on its 2009 guidance. Microsoft blamed the macro-economic weakness. But other firms like Intel (INTC), IBM (IBM), Apple (AAPL) and Google are not showing any signs of the weakness Microsoft is blaming. There is something more happening and the bosses in Redmond know it.

The PC: The Mainframe of the 21^st Century

Microsoft is at the same point where IBM and mainframes were a quarter century ago. The PC and Windows freed the average user from dealing with mainframes and the gurus who ran them. PCs were much less powerful than mainframes but their power was good enough.

We are at a similar point right now. Users want to be able to do everything, anywhere, anytime. They do not want to be bound to their desktop or their laptop or even a particular brand of a smart phone. They rarely need the power of a quad-core CPU. They are no longer willing to pay a lot more for software than the hardware, especially when hardware multiplies. Like many users, I have at least three or four computers I use regularly. Purchasing a license of a Microsoft OS and Microsoft Office for each machine is too expensive and not worth it. I want to be able to use my applications from anywhere but I will not keep multiple copies of the same file or pay for multiple copies of the same software.

Operating Systems: Windows Everywhere No More

Another key fact which stood out is that Windows is no longer the impregnable castle it used to be. MacOS is growing its market share by leaps and bounds. The iPhone is likely to increase the adoption of the Mac, even in corporate environments. Since it is base on the UNIX framework, it can be easily extended for corporate applications. Linux is anyway the default OS for servers in many organizations.

Productivity Applications: Web-Apps Finally Arrive

The agreement by salesforce.com to start offering Google Apps to its clients was a water-shed event. For the first time, there is an option for a small business to use CRM, and Office Productivity Apps, without having to buy licenses up-front. The end-user can access the applications from any web-connected device and is not bound to any particular hardware or OS.

Anecdotal evidence suggests that about 70% of all Microsoft Office users do not have any need for the advanced features offered by Office. Another 20% use some of the features, but rarely. It is the top 10%, the power users who need the full-fledged power of Office. Microsoft is at the increasing risk of seeing the huge installed base of Office applications erode.

Microhoo: Can Yahoo! do it For Microsoft?

Microsoft has not digested a company as big and diverse as Yahoo before. Further it is not clear that how Microhoo will integrate and work together. Though challenges remain there are obvious synergies:

• Search: Apart from algorithms, search is a game of scale. The rapid increase in cap-ex by Google is an indication of how much the leader will have to spend. A combined Microhoo can get that economy of scale and offer a viable alternative to Google.
• Profitable Online Businesses: Microsoft's internet divisions continue to lose money though Yahoo! has been profitable for years. Whether it is web-apps or cloud computing, Yahoo can help Microsoft wean-off its declining desktop franchise. Further, as a pioneer in the internet age, Yahoo! might (just might) have some of its original creativity and innovative spirit left in it.
• Foreign Relationships: Yahoo has made increasingly profitable investments in ventures like Alibaba.com in China. A less abrasive and more conciliatory Microsoft can use those as a launching pad into other emerging technologies and platforms.

There is no other company out there which can bring so much to Microsoft. A properly executed merger can revive the fortunes of both also-rans.

Mr. Ballmer: Forget the Bean Counters

Microsoft is at an inflection point. It needs to take actions to preserve its legacy. These actions are going to be strategic in nature and the ROI will be measured over years, if not a decade. These actions will require a leap of faith. Further, they will not get approval from bean counters who are not chartered to look beyond the current quarter or year.

However, it seems that Microsoft's executives are spending too much time listening to the bean counters and Wall Street pundits who do not want Microsoft to bid against itself. These pundits forget that Yahoo, in its present form, is not for sale. A long drawn proxy battle will drain the value of Yahoo's key franchise. Unlike Oracle (ORCL), which bought companies for their installed base of customers, Microsoft also needs some of Yahoo's DNA. That talent will flee in a hostile takeover.

A Higher Offer: How much will it Cost?

The $31 original offer corresponded to a deal worth $44.6B. A $35 offer, which many believe might do it, would correspond to around $50B. Microsoft's current market cap is around $280B. Another $5-$6B is not a big deal in the big picture; it is just 2% of Microsoft's market cap. However it can turn what can be a losing proposition into a win-win for everyone involved.

Microsoft's bid in the first place was seen as a sign that the giant from Redmond is seeing cracks in its armor. No-deal now, will expose Microsoft to further questions about its future, especially after the weak results this quarter

Microsoft's stock has traded within a range of $28-$32 since the offer was announced. How much difference will a 2% increase make? Microsoft has been underperforming Yahoo! over the past five years. Perhaps a merger with Yahoo is what Microsoft needs to get back on track.

click to enlarge

Disclosure: Author holds equity and equity option positions (both long and short) in all the companies mentioned including Yahoo! and Microsoft.

Comments

[deaverb]

Vista and Office are tired and challenged by MAC, Openoffice.org, and anger by Microsoft's consumer/corporate base. People and organizations are dying to "escape." That's what the "heart" of the problem is. Yahoo is a distraction. Perhaps intentional--they are brilliant in Redmond and shrewd.

[AJ,WashingtonDC]

hmmm. sage advice. it presupposes, of course, that MSFT has a heart. :)

[atauber]

thw whole way Ballmer talkes shows him what he is an agresive rich boy trying to grab a toy his mama isent giving him.

[WAKEUP]

You have very deep suspicions about Microsoft's future, don't you? So do I.

[Malkiel]

You talk in vague generalities here, but some commitment to the issues is required--do you believe OS software will be replace by online services or not? And if so, how soon? And do you believe Apple's expansion from its meager base of 4% of the market to 4.8% of the market is a meaningful trend yet? Do you consider Apple and Linux penetration into the market a significant or growing trend, or not? And with every company on US exchanges failing guidance because of general economic conditions, is there something unusual about Microsoft's particular failure?
And why would first-rate companies choose any office suite software other than the world's best at the current moment, even if many of their users don't need the advanced features? MS Office is the de facto official office suite of the MAC as well as the PC.

I don't share any of the convictions about where online services or software are heading that some, including Microsoft's own executives, seem to pull out of the air so easily. Microsoft is currently the world's best software company and they should maintain and sustain that part of their business as long as possible, especially refocusing on retail customer satisfaction. The bid to buy Yahoo has to do with Ballmer's obsessive but wrong belief that Microsoft is about to be steamrollered by companies that are about to monetize online services (while Mac's partner AT&T, aka "the internet" since its wires ARE the internet, is warning us expansion of online services will collapse the current infrastructure) and I don't give a fig one way or another how this bid turns out because I consider it irrelevant. Microsoft can afford it at whatever price, either buy it and be happy or don't buy it and give your shareholders a dividend. In either case, stop obsessing about long-term plans that are so long-term they go beyond the age of the whole industry that nobody predicted would come into existence just 15 years ago...

[John Capozzi]

Most companies are starting to gve software away for free. The future is in Search & Add Revenue which Yahoo has always showed a profit and has been making great partnerships with major news media companys and papers. Plus Yahoo has Allibba and Softbank which is where a large portion of Search and Add revenue is already showing major fruit and that is in Asia and India. You can even see a major team up of Allibba and Softbank making a major bid for Yahoo at over 40 to 45 dollars a share and backed by the Chinese Government with the ties that Jack Ma CEO of Allibba has. China gave funding to Lenovo to buy out IBM'S personal computer sector and is doing well. What mkes you think that they will not do it for Allibba and Softbank? China's iternet service sector is the largest in the world and search and Add revenue will be a big part i the future. With Yahoo's products these three companies could only give another gain in major market share for the Chinese economy. My bet stays Microsoft raises bid to 35-38 this week or loses. You can even put AOL in the mix of Allibba, Softbank and Yahoo USA and even see more Search and Add revenue a lot quiker. This might be the way to go and give Yahoo ivestors more value in the long ru and watch Microsoft die in the next 2 years were their products are not as much appealing. Microsoft RAISE YOUR BID 35 TO 38 TO START AND GO FROM THERE. IF YOU DO NOT DO IT THIS WEEK I TRULY BELEIVE YOU WILL NOT HAVE ANOTHER CHANCE. Microsoft can afford to raise the bid to 35 to 38 and keep high grade Yahoo employees who have major options in Yahoo. They do not want to be undersold. It will not be easy to throw out Yahoo's board in July and then Microsoft has the time frame which Google is grabbing major market share. Yahoo will not wait till the end of this week. They cannot afford to do it. The first move they will make is bringing in AOL AND TIMEWARNER. So MICROSOFT RAISE YOUR BID TO 35 TO 38 AND GET Yahoo, Allibba and Softbank to the table. Close this deal this week or you are going to lose Yahoo. Hostile takeovers normally do not work and you lose key employees of Yahoo. CLOSE THE DEAL NOW MR. BALMER AND DONT USE THE MEDIA AS A PLOY. Everyone knows the game and it is not working now over 90 days since the bid was given.

[blah-blah]

Not a bad article and compared to usual Microbashing that's in fashion on this site, something different for a change.

Unfortunately Malkeil really nailed it - Being in IT, I can tell you I would be let go for giving everyone the inferior OpenOffice(far superior to Google Apps). Corporations are not going online for everything - I did the numbers and it's more expensive(Internet bandwidth alone) than licensing for all but shops with 10 users or less not to mention inferior apps + extra security and DRP risk(if the Internet is down, the company cannot - email can be sent out a cheap slow backup link in a pinch, Office can't).

It's obvious from the commenters and authors, few if any work in IT or they'd understand that software is cheap, people and downtime is expensive. Whining about a $400 or $500 license per user once every 4 years to a corporation is just plain dumb - it's pennies compared to the alternative - one bad project can wipe that out. Online makes sense only for the inidividual user and very small companies.

One thing - this statement is actually 100% wrong

'Linux is anyway the default OS for servers in many organizations'
Linux actually lost a little market share last year - Windows Servers stand at 69% - remember Vista and Windows Server 2003, SQL or Exchange are very different groups - don't judge the backend by the client OS.

[jayme]

its not about google apps, yahoo apps, or the "software world going online"

i will not talk trash about the author, but please, why insist on this "its all going online"

its about the damn freewares populating cyberspace, well said, the guy who mentioned openoffice.org and many other in initiatives

bandwith is still a problem, plus, there are tons of places you cannot get online through broadband, you would need a fast quick old fashioned dialup solution. thats where thoes web apps, fail, and once again it comes down to the freewares like, openoffice
lets not forget that, combined office and windows represent 90% of microsoft revenue.
now, its delusional to think that "not buying yahoo will sink them(them = microsoft)"
believe me pal, this guys at redmond got tons of aces in their sleeves, and can affoard to spend 40 billion, in something else. that would turn out to be better, easier and more lucrative.

by the way,
MAC OS AND LINUX (UBUNTU AND ITS TONS OF OTHERS DISTRIBUTIONS) do not threat windows at all.
firefox does this to internet explorer.
but as an OS, windows is the supreme king.
no dethroning anytime soon.

PLUS:
MAC WOULDNT BE SELLING THAT MUCH IF JOBS HADNT REALIZED THAT DUAL BOOT WAS A MUST.

i know people that buy macs, just for the sake of having a mac.
they dual boot it, and install windows.
thats is.

mac is esthetic's, is fashion, is cute. and thats all.
its a cpu brand, like prada is for clothing.

[Vikram]

Folks:
Thank you for your comments.

1. When I said 'servers are linux' I meant non-Microsoft eco-system based servers which confirm to open standards (think Apache vs IIS). Exchange, Windows 2003 and other prop MS servers continue to operate in an MS based environment.

2. Web-Apps are now moving to a point where they do not require a persistent internet connection. They can save a version in a local cache and then sync it with the server when the device goes online.

3. Some of the comments from commercial IT workers, echo the comments which were made by mainframe managers 25 years ago. As workers start computing from a larger number of devices, the software cost for each device will become significant. At home I am reluctant to buy multiple licenses, one for every machine. This is also true in other small business environments which do not have site-licenses or dedicated IT staff.

4. Apple's move to Intel CPUs and subsequent support for Windows has certainly helped accelerate the adoption of Macs since it removes the one remaining reason not to get a Mac (i.e. how do I run legacy Windows software). However, to claim that people buy Macs to look cool and then run Windows is hard to accept. Though I do not yet own a Mac, it is likely that my next purchase will be one.

5. Bill Gates recently stated that the next Windows version will be released sooner than what everyone expected. Ballmer has let out hints that XP may live on longer than expected. Vista has been a disappointment and an illustration of how Windows/PC setup is becoming disconnected with the needs of the average user. I waste precious time responding to the same security messages and compatability warnings when using Vista. Instead of making the user experience seamless and intiutive, Vista forces the average user to worry about unproductive, tangential issues; issues which many of them have little capability of resolving except by pressing the OK/Continue button (which defeats the entire purpose of the warnings)

[hedge fundtrader]

msft probably needs yahoo long term, but in the short term they can get a better price for such a piss poor managed company. Msft probably doesnt have the votes that they need for a proxy fight, at least that is what it sounds like.

lets not forget one very important rule in merger arbritrage, many hedge funds and mutual funds and other large investors started adding yahoo positions in light of the deal being done at 31$. these huge postions that financial institutions have been putting on is quite substantial. can you imagine the outrage if ballmer said we dont need the hassle and pulled the bid and yahoo's stock fell back into the high teens.

these hedge funds and large investors would be calling for yang's head on a pike! and lest we forget Yang is the youngest CEO of any fortune 500 comany, so i would be carefully of his great business judgement.

ok, ballmer are you listening? this is what you can do.....
pull the bid, see the stock fall then start recruiting all these hedge funds and large insitutional investors on your side.
oh yeah and lets not forget that unrealistic profit forecast yahoo gave last week at their earnings release, they fluffed their profit forecast trying to call microsoft's bluff to raise the bid and msft did not blink, now when ballmer pulls the bid and when yahoos next earnings come out they will miss big time, and then msft can come up and offer 25$ a share and yhoo shareholders will run to that offer.

proxy fit will take 6 months anyway. this is the better way to do it and you can save about 15 billion dollars in this 25$ offer.

your welcome!

[smkngrbt]

Jayme,

You are ignoring the world of software products that consistently perform better on lower end Macs, or just Macs in general. Examples are music production and graphic design software. I own a PC that is moderately behind current technology in terms of CPU speed and RAM (i could tack on an extra gig and be current there for not a lot of $), but these products not only have a better look and feel (in terms of using them) on Macs, but run smoother. The PC is the better choice amongst the casual computer user and obviously the best in terms of gaming but for aficionados in the design and music industry, the Mac is standard. The companies design the software with the mac in mind. That said, Mac is NOT just aesthetics, fashionable, cute, maybe for the common and larger market share of computer users macs are "cool" but in the realm of specific usage it is a better system. PCs have been playing some serious catch up games but even so there are still a multitude of problems with Intel (or PC) chipsets that the Mac doesnt have.


On Apr 28 01:29 PM jayme wrote:

> its not about google apps, yahoo apps, or the "software world going
> online"
>
> i will not talk trash about the author, but please, why insist on
> this "its all going online"
>
> its about the damn freewares populating cyberspace, well said, the
> guy who mentioned openoffice.org and many other in initiatives <br/>
>
> bandwith is still a problem, plus, there are tons of places you cannot
> get online through broadband, you would need a fast quick old fashioned
> dialup solution. thats where thoes web apps, fail, and once again
> it comes down to the freewares like, openoffice
> lets not forget that, combined office and windows represent 90% of
> microsoft revenue.
> now, its delusional to think that "not buying yahoo will sink them(them
> = microsoft)"
> believe me pal, this guys at redmond got tons of aces in their sleeves,
> and can affoard to spend 40 billion, in something else. that would
> turn out to be better, easier and more lucrative.
>
> by the way,
> MAC OS AND LINUX (UBUNTU AND ITS TONS OF OTHERS DISTRIBUTIONS) do
> not threat windows at all.
> firefox does this to internet explorer.
> but as an OS, windows is the supreme king.
> no dethroning anytime soon.
>
> PLUS:
> MAC WOULDNT BE SELLING THAT MUCH IF JOBS HADNT REALIZED THAT DUAL
> BOOT WAS A MUST.
>
> i know people that buy macs, just for the sake of having a mac.
>
> they dual boot it, and install windows.
> thats is.
>
> mac is esthetic's, is fashion, is cute. and thats all.
> its a cpu brand, like prada is for clothing.