The buzz in technology and investment circles over the past few days has centered on analyzing the economic and technological implications of Microsoft’s (NASDAQ:MSFT) search deal with Yahoo (YHOO). While both Microsoft CEO Steve Ballmer and Yahoo CEO Carol Bartz claim that the deal represents a “win-win” arrangement for both companies, investors would beg to differ. Microsoft shares jumped strongly on the news and Yahoo shares have plummeted. Despite the stock market’s tendency to overreact to news, in this particular case it appears that, at least from a directional perspective, Mr. Market may be on to something.
The Clouds Dissipate Over Redmond
Microsoft had a difficult fiscal year ending on June 30, 2009 with overall revenues and operating income declining from the prior year, but the company demonstrated resiliency given the overall economic conditions experienced during the year. What is more important, however, is what did not take place over the past eighteen months. In early 2008, Microsoft proposed an unsolicited takeover bid for Yahoo initially valued at slightly over $44 billion, and the bid was subsequently raised before the deal eventually collapsed.
Microsoft shareholders have former Yahoo CEO Jerry Yang to thank for his consistent refusals to agree to a deal at $33 per share. It appears that Microsoft has accomplished the bulk of what Steve Ballmer was attempting to do last year without spending any cash up front. Despite Carol Bartz’s statements earlier this year, Microsoft did not have to pay Yahoo a “boatload of cash” in order to strike a deal.
Here is a brief excerpt of Steve Ballmer’s comments Thursday at the Microsoft Financial Analyst Meeting regarding Yahoo’s upside from the deal:
On the Yahoo side — and this is the one that stuns me that people haven’t figured it out —Yahoo gets 88 percent of the search revenue they have today. They have zero percent COGS against 88 percent revenue, and they have no R&D expense and no ongoing CAPEX. It’s sort of like unbelievable.
Too Modest, Mr. Ballmer
Mr. Ballmer is too modest in terms of what the deal does for Microsoft shareholders. Microsoft acquired the rights to license Yahoo’s core search technology for a period of ten years and will be able to incorporate this technology into the Bing search engine where appropriate. Bing will become the “engine” behind all searches on Yahoo sites and Microsoft will retain 12% of search revenues generated on Yahoo’s sites. Microsoft will retain all revenues associated with Microsoft’s sites while Yahoo will serve as the sales force for both companies’ advertising business.
While Microsoft has provided Yahoo with certain revenue guarantees for operations in certain countries for the first 18 months of the arrangement and will face some one time integration costs, there are no other cash outlays required.
Of course, this arrangement will also lift Bing’s share of the market significantly and will do so very quickly. Microsoft obviously must continue to spend on R&D for search, but this is an expense that the company would have incurred regardless of the Yahoo arrangement. Yahoo is relieved of such R&D spending and essentially becomes a media company.
While Yahoo should see some incremental operating income as a result of the deal, it sure sounds like Microsoft has accomplished what it intended to do in the $40+ billion acquisition attempt last year but without laying out a single dollar in cash compensation to Yahoo
Microsoft’s Cash Machine
While Microsoft did experience a difficult fiscal 2009, the combination of an improving economy and a large number of new product releases should improve results for the coming fiscal year. From a technical perspective, Microsoft has good answers for the advocates of “cloud only” computing where all data and application logic resides on servers rather than a user’s computer. Microsoft’s software plus services approach appears to be more compelling.
The Client and Microsoft Business Division segments have been and will continue to be cash cows for the foreseeable future. Server and Tools was the only segment to show increases in revenue and operating income in fiscal 2009 and should show strong growth going forward. Microsoft’s other business segments, including search related businesses, now have a much brighter future than prior to the Yahoo deal.
With the risk of a very expensive acquisition of Yahoo now off the table, investors have a much less murky scenario to deal with when it comes to valuation of Microsoft. Many value investors have already taken positions in Microsoft at lower prices, but had to assume the risk that Microsoft may spend a large amount of cash on acquisitions. Now that risk is largely eliminated. Cash can instead be used to repurchase shares or perhaps pay a large one time dividend as the company did in 2005.
Under any conceivable scenario, the free cash flow generated by Microsoft through its businesses with large economic moats should be available for the benefit of shareholders. This reduces uncertainty and increases the margin of safety even at the higher prices prevailing after the deal was announced. I anticipate that more value oriented investors will be attracted to Microsoft shares at current prices.
Disclosure: The author purchased shares of Microsoft yesterday.