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Pee Dee
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Professional investor, Cogitator and periodic Agitator.
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  • Asset Valuations: Microsoft Corp., Skype Global S.à r.l and Strategic Values
    Let’s start this post with two observations.
    First, the mergers and acquisitions (“M&A”) dances between and amongst corporate leaders of major companies are often portrayed as either personal where egos drive the transactions or professionally-sterile where the numbers crunching bankers and consultants flip endless slides of presentations and spreadsheets. Such caricatures have an element of truth. Yet, as usual, the reality lies somewhere in the middle—usually.
    Second, business schools for several decades now have taught that an asset is worth its expected or future discounted flows, where such flows could be earnings, dividends, cash or other benefits seen as accruing or paid out to a business’s owners. 
    Corporate finance salesmen (a.k.a “investment bankers”) and consultants sometimes add some shortcuts to those complex formulas by using a couple other methods; the most popular of which are based on either (a) current ratios of comparable publicly-traded companies’ average common share prices relative to their expected earnings, cash flows or industry-specific metric (e.g. “proven reserves” for certain minerals and energy companies) or (b) the implied total value of a company based on what the buyer paid to acquire a controlling interest in the business relative to similar reference metrics in (a).  Both are usually expressed as multiples of the reference metric (e.g. 10 times, or 10.0x, earnings; or 7.0x cash flow). Both are based on the premise that an asset is worth what someone’s willing to pay for it. (a sort of specious logic as perhaps a well-retired luxury goods saleswoman would explain to her curious daughter and suggested below).
    While no valuation method is ever precisely correct (though they can yield precise answers with several post-decimal point digits) nor “the best”, these business school physics-envy, finance approaches miss a critical point where marketing and economics can often-times lend a hand: strategic value.
    We’ll herein discuss how strategic values, when combined with personalities of company captains, impact the dynamics of major M&A by looking at the recently announced planned merger of Microsoft Corp. and Skype Global S.à r.l.
    It was announced on May 11, 2011 that Microsoft Corp. (“Microsoft”) of Redmond, Washington would acquire Skype Global S.à r.l (“Skype”), headquartered in Luxembourg. While the former is well known the latter may need a brief introduction.
    As the internet was becoming available to mass consumers during the ‘90s, quality voice communications over the web, referred to as Voice over Internet Protocol (or “VoIP”) was seen as one of the Holy Grails of future fortunes (along with ecommerce, video streaming, etc). There were several technology startups during the period that sought those fortunes and nearly all of them failed; often because of their low audio quality and, just as often, poor business models.
    During this period an innovation was introduced allowing users to connect to each other over the internet for video or telephonic calls. This innovation became and continues to be a standard referred to as Session Initiation Protocol (or “SIP”). Unlike its predecessors and contemporaries, SIP had the advantage of being freely-available and freely-modifiable to anyone with the skills to utilize it.  Such software offerings are often called “open-source” applications and the typical user spans from communications hobbyists to techies to corporate users.
    Along comes Skype which launched in 2003 on the cusp of mass deployment of speedy internet connectivity technologies such as wired broadband and 3G mobile phones. Skype developed a “close-source” solution that significantly improved the sound quality of internet calls. Skype’s single innovation over SIP however was as simple as what every successfully-designed consumer product has: features that make the challenging look easy. In other words, Skype took the geek out of VoIP.
    Yet the difficulty for Skype was two-fold: as a “closed” network, users could only call other Skype users initially like the earlier failed attempts. The only way to break out was to offer the product at a low cost. Skype decided to give it away and allow users to call other users for free to build a network, which becomes stronger as the sound quality improved when greater numbers of users joined. The second phase of Skype’s business model kicked in with low-cost calls to non-Skype users on their landline and mobile phone numbers. This is where the revenues began to come in.
    The challenge for Skype was, and continues to be, how to convert those free users to paying customers. We’ll discuss that in a moment.
    As the new millennium witnessed increasingly smaller technology devices with greater capabilities, the new-new thing was device that nearly every adult carried with him or her: the smartphone—ostensibly a phone, yet with user-desired features like internet browsers, digital maps and clocks and, of course, phonebooks amongst other uses.
    Realizing that this phenomenon risked the future viability of it Windows franchise, Microsoft decided to pursue the smartphone market with Windows Mobile—it unanimously failed. Users complained about its slug-like speed, lack of features and weak designs. Meanwhile, Apple, Inc. and Google, Inc. had launched widely acclaimed phones and software for their respective phones.
    Needing to do something, Microsoft went looking for opportunities to inject its Windows franchise on mobile phones. First came Finland’s Nokia Corporation (“Nokia”) with an announcement earlier this year to, in short, jettison its whole software development team and subscribed to Microsoft’s Windows Mobile. There was a problem with this however. Tying two rocks together doesn’t usually help them float any better as Nokia’s market share in smartphones cascading lower.
    Meanwhile, Skype had gone through a rocky marriage and divorce after being bought by eBay, Inc and then the latter’s controlling interest was subsequently sold to a group of private equity investors who had registered to sell common shares of a Skype-related entity, Skype S.à r.l., in an initial public offering to raise an indicated $100mn at an expected $7bn valuation.
    The questioned remained for Microsoft: how do we get our Windows system onto people’s phones when we are behind in developing a viable competing product and our franchise risks becoming obsolete? Simple—let’s play to our strengths in distribution, available capital and influence. This is where the merger comes in.
    When Microsoft announced its planned acquisition of Skype for $8.5bn, many a head went scratching. Why would Microsoft pay such a great sum for a company with declining growth, a relatively small number of highly-prized (read paying corporate) users, an assumed high paying customer churn rate and whose technology still faces declining margins and obsolescence? With reference to Microsoft’s $50.2bn cash horde as of March 31, US Treasury Bill interest rate yields may be low yet they still are not negative.
    As of December 31, 2010, Skype S.à r.l. (the “IPO Entity”), the entity that was to be listed for $7bn that is substantively the same as Skype, had total assets of $3.32bn of which $3.00bn was goodwill and intangibles. Long-term debt was $686mn and shareholders’ equity was stated at $2.25bn.
    For the fiscal year ending December 31, 2010, the IPO Entity reported $859.8mn in revenues, $444.1mn (51.7% margin) in gross profit, $210.2mn (24.4% margin) in net operating cash flows before balance sheet adjustments and $135.0mn (15.7% margin) in adjusted operating income. The simplest valuation calculation here is that Microsoft is paying about 10.0x revenues, which impressively grew at 19.6% over 2009 revenues but significantly less than the prior year’s 30.4% growth, for Skype.
    The preliminary prospectus for the IPO Entity contains the following gems as risk factors (
    • [L]arge incumbent telephone companies with significant financial resources, may attempt to gain significant market share from us by offering their communications products for free or at prices at or below the prices we charge, which would have a material adverse effect on our business.
    • Many of our products are free. As a result, we have generated nearly all of our historical revenues from our paid communications services products, which are purchased by a small minority of our users.
    • The number of our registered users overstates the number of unique individuals who register to use our products.
    • Our connected users metric is subject to uncertainties and may overstate the number of users who actively use our products.
    • …Google has recently acquired Global IP Solutions, which has developed a real-time audio and video-over-Internet technology similar to ours. Google may use this technology to compete against us. Google has also recently expanded its internet communication services by enabling U.S. and Canadian users of its “Gmail” email service to call landlines and mobile phones from their e-mail inbox.
    • Domestic and international telecommunications prices have decreased significantly over the last few years, and we anticipate that prices will continue to decrease.
    A secular trend has happened around the world: nations are raising the importance of their information technology (“IT”) and communications sectors to better compete with other nations.  In this regard, some nations, such as India, have sold mobile phone licenses to almost anyone who wants one in part to support its IT sectors but at a significant cost to mobile network operators such as Vodafone plc. Unbeknownst to most Westerners, China has some of the lowest mobile phone rates in the world with rates in Hong Kong being offered for less than one US penny per minute and in China for marginally higher.
    Microsoft has recently not had good experiences with pricing some of its own products when the cost of the required hardware has dropped faster than its innovations can keep up. Hardware makers, responding to consumers, begin looking for alternatives when the software-to-hardware ratio passes a certain threshold.
    THE “WHY” IN M&A
    All this leads us back to questioning why Microsoft is acquiring Skype at such a great figure of $8.5bn. The quick answer is Skype’s strategic value.
    While, this poster had no vantage point to observe or be involved with this merger negotiation, it may be fair to speculate that one of the principal sellers of Skype, Marc Andreessen who founded what became Netscape Communications Corporation. (“Natscape”), may have viewed this transaction as retribution against the giant entity that decimated his innovative fledgling. Andreessen and Microsoft’s past squabbles and a recent Bloomberg story ( could lead one to believe to speculate so.
    More importantly, Skype gives Microsoft an edge with the most crucial and pivotal stakeholder in wireless communications: the cellular / mobile network operators. These operators select which phones to support by offering financing for mobile phone sales through long-term contracts with users. This is the node in the architecture that gets to decide which product, and hence mobile system platform, will succeed in the marketplace.
    Though it is not and will not be said explicitly, it seems highly likely that Skype will be a shadow trump card used in negotiations with mobile phone companies to adopt the Windows Mobile platform. With a super-dominant market share in personal computer operating systems around the world, Microsoft can place Skype at everyone’s fingertips with a single Windows update. That move could lead to many more users seeking to adopt Skype’s mobile versions. These mobile versions will almost certainly reduce the volume of voice calls carried by network operators that have five times greater margins over those for data traffic.
    Why would Microsoft do this since it would kill its investment in Skype? Microsoft will have a sunk cost of about $8.5bn after completing the Skype purchase and some additional costs for system integrations. That cost and Skype’s $860mn in revenues is the maximum it can lose in a game of chicken with the network carriers. Verizon, Communications, Inc. on the other hand during its fiscal year ending December 31, 2010 earned $55.6bn in US domestic wireless revenues, the bulk of which is the more profitable voice-related rather than data services, and made total capital expenditures of $16.5bn. Network owners stand to have the most profitable part of their entire business advanced towards obsolescence and risk some meaningful part their heavy capital expenditures.
    A scorched earth strategy by a declining semi-monopolist would scare even the biggest stalwart companies. This suggests that should Microsoft employ this strategy and the operators play along, Windows Mobile can succeed by being widely available in the marketplace and the carriers will do just as well as before though users will have fewer choices.
    Corporate valuations encompass much more than the multidimensional discounted-methods taught at business schools and the comparative models used by corporate finance salesmen. By taking a strategic perspective in this transaction, we can see that Microsoft Corp. is buying various strategic “options” with its intended acquisition of Skype Global S.à r.l; the most important is its ability to expand its Windows franchise to mobile devices. With Microsoft’s Hotmail and X-Box 360 franchises already having free voice and / or video features, it’s unlikely Skype is filling a technology void in Microsoft’s array of products. Microsoft however does not have VoIP adoption or a brand like Skype has, which when combined make Microsoft-Skype a powerful threat to phone network carriers.
    The risk factors listed above, most notably the adverse pricing trends for VoIP products; the failed initial public offering of the last major VoIP common stock offering for Vonage Holdings Corp. and the serial delays for the Skype IPO Entity, and a purported shortage of bidders for the company all seem to suggest that Microsoft could have make this purchase at a lower valuation, especially since it is common for private transactions to have lower valuations.
    Regardless whether its past experience with Netscape adversely affected the price paid, Microsoft may now be able to enjoy renewed vigor in a market that threatened to leave it behind.
    May 15 11:07 AM | Link | 2 Comments
  • Why Wal-Mart's Expected Purchase of Massmart Could be Good Deal
    It was announced Monday that the world’s largest retailer, Wal-Mart Stores, Inc. of the US, has entered into exclusive negotiations to acquire Massmart Holdings, Ltd. of South Africa for R148 or about $4.6bn.  This transaction, if completed, is a potential game-changer in global retailing and goods production.

    Unlike, say, ASDA, Massmart operates in over a dozen African nations where GDP growth rates are more than twice or three times that of developed economies.

    Because of a lack of commercial capital, there is little supply of goods in these markets and lots of demand making even sundry items extremely expensive partly owing to lack of competition and cottage-industry businesses. Worse, the quality regardless of price is unusually poor. If this sounds familiar to small-town America and its low income urban counterparts before Wal-Mart's arrival, it's even worse.

    Massmart recognized this two decades ago and has benefited handsomely for it.

    One of the best metrics Warren Buffett says gets his interest is a company earning a return on equity of at least 20% per year consistently for 10 years.  Judging Massmart by such metric leads one to conclude it’s got an interesting business as exhibited below:

    2010: 34.0%
    2009: 41.7
    2008: 50.7
    2007: 52.3
    2006: 48.9
    2005: 44.2
    2004: 42.8
    2003: 35.4
    2002: 27.6
    2001: 19.1
    2000: 24.9

    These numbers are even better than Target Corp.'s very impressive figures.

    Some may state that the above figures are boosted by inflation, which is true.  For an operator such as Massmart, moderate but stable inflation is actually a benefit as its carries a low-to-negative working capital balance; a cheap source of financing at sometimes negative costs similar Wal-Mart’s financing.

    In addition, this transaction may accelerate the increase of local production in Africa as certain southern African states are already serving the continent from their local bases though this production may find stiff competion from Asian goods.  This could further complement Wal-Mart's ex-Africa businesses over the long-term to find competitive sources.

    I've written here about why investors (rather than operators) in developed countries should avoid investing in emerging economies and provided a brief overview and history of such investments (see here “Emerging Markets? No, Thank You!” Part 1, Part 2, Part 3 and Part 4).

    Though Wal-Mart Stores, Inc. has it's work cut out for it as the recent South African unions' opposition to the transaction demonstrates, if it goes through this looks to be a potentially good deal that combines a proven management team, a (virtually preexisting Wal-Mart) platform of low price-high volume, and extraordinary room for expansion with the decades-long technological and supply chain experience of the buyer.

    One may question whether Africa's growth rate is sustainable (though we must remember it's comprised of over 50 nations) and setbacks such as Kenya's in 2009 will occur here and there, but the geographic diversity of 14 nations could help buffer that.  Meanwhile, there are no continent-wide retailing flagships and very few national champions to compete against on this scale.

    Purchasing such an option for about one-third of a single year's net income is probably not a bad deal and provides Wal-Mart Stores, Inc. investors participation in an emerging continent's growth.  This is one of the best ways for a Westerner to invest in emerging markets.

    Disclosure: The author owns no common shares in any of the aforementioned companies.
    Sep 29 6:19 AM | Link | Comment!
  • Emerging Markets? No, Thank You! (Part 4 of 4)
    In the third of a four series blog post, I explained why investing even small sums in emerging markets ("EM") is not worth it.  In this last blog post, I exhibit a highly respected fund manager and how his past and present investment experiences serve, respectively, as point and counterpoints to my argument against most non-EM-based investors sending their capital to EMs.

    Anthony Bolton as Point and Contra-Point

    Almost one year ago, Fidelity International's esteemed investor Anthony Bolton announced he was coming out of a brief retirement to start investing in China.  Now, for those unfamiliar with Bolton, he made his name managing a UK and Europe focused fund over a 30-year continuous period and earned 19% per annum--that's 185x for those keeping score.  Those returns are even more impressive considering that these investments were of companies operating in a European ecosystem of slow growth, double-digit unemployment, little innovation, stagnant populations growth, and terrorist attacks at home to boot.  Despite all that, he still returned 185x--unlevered--in a sizeable mutual fund.  That's better than most US-focused fund managers during the same period who enjoyed the winds in their sails of a more economically dynamic ecosystem.

    Mr. Bolton's example brings home the idea that it's not the GDP growth figures that should take primacy in common stock investing for better returns, it's the discount to valuation price paid for the common stock of the business and its managers.  Even if the US's best days are behind it, which Buffett highly doubts, the investment opportunities could be very rewarding as Mr. Bolton's experience demonstrates.

    "But Even Buffett is Investing in Emerging Markets"

    Over the last few years, Warren Buffett has also made striking investments in common stocks of EM companies and at least one of their currencies.  It is therefore reasonable for one to ask, "Buffett invests in EM.  Are you smarter than he?"  The quick answer is "no".  The query warrants a closer inspection.  Berkshire Hathaways's media-friendly investment in BYD, a Chinese auto batteries maker is often attributed to Warren Buffett though that is unlikely.  The decision to do so seems like it was jointly made but led by BRK's head of MidAmerican Energy, David Sokol.  As a self-described technophobe, Buffett seems unlikely to have invested in a Chinese battery-technology startup.

    Buffett did however score coups the common shares of PetroChina Co. Ltd. as well as a basket of South Korea's largest companies.  On a closer look, one notices that he purchased common shares in these companies at significant discounts to their fair valuations and these companies had either assets traded around the globe, e.g. crude oil, or had global businesses with heavy exports, e.g. Samsung and Hyundai chaebols.  Many of the Korean companies he bought common shares in traded at 3x-5x earnings.  What's further interesting is how quickly he disposed of all those investments once they appreciated.  He clearly did not think these were Washington Post, Inc. businesses worth owning their common shares continuously for decades.  He has however staked Berkshire Hathaway's future on--get this--a railroad business in the United States.  It's worth noted where Buffett places his wallet rather than his weekend pocket money.

    Mr. Bolton's recent post-retirement venture in China, where he moved to Hong Kong, raises the question whether his prior experience is replicable in such a market and then if investors should follow him.  Time will answer the former question though the arguments made in this blog series accords it low probabilities.  With regards to the latter, the last page of Chapter 20 of "The Intelligent Investor" reads:  "You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right."

    The historical data and the reasons behind the performance of EM common stock investing, whether the US 1900-1950 experience or EMs during 1990s, lead one to question the wisdom of following even the sharpest minds there.  Even Warren Buffett may not warrant a following into EM.

    There are many more reasons for non-EM-based investors to keep their capital home not least is recurrent xenophobia; underdeveloped legal and commercial systems; and corporate governance, or lack there of.  The arguments made in this series should provide most investors with sufficent reasons to avoid EM common stocks.

    I wrote this blog series partly to help a friend who's a professional investor in emerging markets.  I hope others find it useful and, at least, gives them a jumping-off point for further enquiry.

    Comments and suggestions are welcome.

    Disclosure: The author owns no common shares in any of the aforementioned companies.
    Sep 20 9:26 AM | Link | 3 Comments
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