The point of view depends on the point of view
Many times in writing articles, contributors can take the point of view that they "know better." I am guilty of that as anyone I suppose. When people look at things like a merger, especially one of the magnitude of Microsoft's (NASDAQ:MSFT) buy of LinkedIn (LNKD), there is often a tendency to look for the flawed logic and misguided strategy that may have motivated the acquisitor. Life is not really made up of brilliant strokes that meet everyone's approval. Microsoft has certainly made some significant errors in terms of its acquisitions. Obviously, the deal to acquire Nokia's (NYSE:NOK) handset business comes to mind. But in this case, I think that most of the critiques are coming from people who don't want to consider the point of view of management in making this deal.
Microsoft, like many "old" software companies, has been in transition for a few years now in an effort to remain relevant. Revenues have stagnated now for almost three years, and the last reported quarter was not a thing of beauty by the estimates of most observers. The point of view of this management team is clearly that there are things to fix, things to improve and that time is an important consideration in its strategy.
Buying LinkedIn is unquestionably, on the surface, a strange step. It doesn't readily fit neatly into a corporate strategy pigeonhole. Most observers might have hoped that MSFT would be able to make a much smaller deal to acquire a cloud applications company. But when carefully considered, that strategy, from the point of this management, is likely fatally flawed. Asking prices for smaller, successful cloud vendors would be astronomic; antitrust considerations would be significant, and most of the acquisitions would simply be too small to accomplish the purposes of this management in a timely fashion. It is my view that what this transaction is all about is simply a way forward for MSFT that is accretive in the near future, has relatively low risk and minimal short-term dilution, is affordable given the company's cash resources and which will have some noticeable impact on Microsoft's growth rate - well a little, anyway - and the percentage of revenues coming from the cloud. That is management's point of view in my opinion, and given the alternatives, I think it is the correct one.
Many, many years ago, I was taught that one of the hallmarks of being a decent manager is to sub-optimize. Things are rarely totally in the control even of the CEO. The available choices may not be exactly what the CEO might have had in mind. But decisions need to be made, and the best needs to be made out of what is available. In this case, while the best doesn't fulfill the conventional wisdom, it is still most likely to produce a satisfactory outcome. The real question at hand is whether or not the acquisition is going to produce positive alpha for Microsoft. As explained below, I hope, my answer is that it will. And that is really the only thing in which most readers have interest.
What is the point of view that has animated this deal?
There is really only a single issue worth discussing in the context of the Microsoft acquisition of LinkedIn. At some level, I do not care all that much as to why the acquisition was made, although it might be an interesting subject. I am interested in determining whether or not buying LNKD will prove good or bad for Microsoft's shareholders. I think the answer to that question is that it will indeed add to MSFT's share value, although I will try to present all of the arguments, pro and con, that readers are likely to consider.
By now, I have counted no fewer than 11 articles on the merger published on SA thus far, and I am sure there will be more. Of the 11 articles, four thought the deal would turn out to be a loser for MSFT, three were undecided, and four were positive. Some of the articles were really using the circumstance of the deal on which to hang other conclusions.
I shall try to bring some clarity to the thicket of conflicting and perhaps polemical opinions. I hope I will provide a bit of value add by doing so, although with so many comprehensive articles, many subjects will be covered one way or the other. And I will try to add a bit of value add to a very lively discussion which encompasses many well defended viewpoints.
As I have written on both of these companies in the recent past, I think that it might be worthwhile for some users to see a continuation of the themes expressed in the earlier articles. At the end of the day, I think the acquisition was really the only strategic move that MSFT could have taken to meaningfully add to cloud revenues, whether or not it's sub-optimal is of far less importance than whether or not the economics are going to work, and to produce positive alpha for investors. I am sure I will not get around to covering all subjects of interest, and I have had to give a short shrift to some detailed examination of the potential revenue synergies, which are what this transaction is about. But I have tried to present the case that despite the seemingly stratospheric purchase price and the strange looking combination, the economics will work - I think the deal makes sense and will ultimately benefit MSFT's shareholders.
I do think that it is important to understand that there are many "right" points of view and they depend, for their substance, on where one happens to be sitting.
Why did this deal get done? At the very simplest level, the board at Microsoft has been seeking to expand the proportion of revenues from its cloud revenues. Steve Ballmer, after a long run at MSFT, was forced out of the CEO role because of the company's slow pace of change in terms of reaching critical mass in the cloud amongst other reasons.
In the wake of what was considered to be a disappointing Q1 and one that saw some growth shrinkage in the business segment called "intelligent cloud," which does not quite mean what the title implies, several press reports discussed that the board overall, and Chairman John Thompson in particular, determined that they wanted to see more cloud revenues. That was management's mandate and it has now been fulfilled - sort of.
In a perfect world, I suppose, it might have been optimal for MSFT to have bought Salesforce (NYSE:CRM) and pay $80 billion - or would it? By all accounts, MSFT's CRM solution is doing well in the cloud-buying Salesforce would come with a fair amount of product and revenue overlap. Microsoft could, as one supposes, spend the $26 billion it is spending to buy LNKD and perhaps gotten some minor amount of change if it chose instead to have bought Workday (NYSE:WDAY). But it already has what WDAY sells, i.e. Microsoft Dynamics, and the purchase of Workday would represent significantly more dilution than the acquisition of LNKD (LinkedIn reported a GAAP loss of $166 million and WDAY reported a GAAP loss of $290 million. LNKD is forecast to have non-GAAP profits of $408 million compared to WDAY's breakeven non-GAAP profits). Of the other potential targets, Adobe (NASDAQ:ADBE) is too large. Neither Ultimate Software (NASDAQ:ULTI) nor Palo Alto (NYSE:PANW) is quite large enough to move the meter.
The final consideration is anti-trust. This transaction is a complementary transaction in that there is really no overlap between what MSFT sells and what LNKD sells. All of the other more "logical" transactions involve high levels of overlap and most probably would not get done in today's anti-trust environment. It doesn't matter how good a deal might be if it can't be consummated.
Other suggestions that I have seen suggest that Microsoft should have bought more traditional cloud application vendors. Most of those are small and expensive. Microsoft would have had to buy several to get the impact that it is getting from this one acquisition. It simply would not be feasible for Microsoft, or anyone else for that matter, to try to complete several large deals simultaneously. If the objective was to get lots of subscription revenue over the short term, then this transaction is actually one of the few available. Given Microsoft's size and its resources, trying to find the right company that ticks all of the boxes must have proven to have been difficult undertaking. I am not too sure that there would have been another cloud vendor of scale that had a more attractive valuation, i.e. one that produced the smallest amount of dilution possible than LinkedIn. Why did Microsoft buy LNKD? In my opinion, because it was the vendor that could fulfill as much of John Thompson's mandate as was feasible given the other inevitable constraints.
How do the valuation and qualitative metrics support the logic of what looks to be an expensive acquisition?
OK, let's go with the thought that Microsoft's management was mandated by its board to buy cloud revenues. Let's assume that current CEO Satya Nadella likes his job and is well aware of the circumstances that led to his predecessor's premature departure. And let's assume that in doing screens, the only company that might work was LinkedIn. I doubt that the deal will not get done - it wouldn't be credible to see anyone come with a higher bid.
I think I ought to discuss some of the cavils that have been suggested by other contributors on this site. It is true that MSFT is an "old" software company. It is trying to reinvent itself, and I believe that it will. But to go through a couple of the points posed by contributor Bill Maurer, I think that MSFT's financial statements are no worse and no better than those of many other software companies that I follow. Microsoft really leaves some observers with less clarity than might be useful. I would love to know, for example, a bit more about how MSFT's transition to what it calls "annuity based" revenue sources have hobbled reported headline numbers. It would be useful to have far more quantification on that subject than the company presently supplies. MSFT is a bit more complex than some other software companies because it sells some hardware. But, for the most part, its financial presentation follows the same order with the same captions as any other software vendor. Since I almost never look at anything other than tech companies, perhaps I am jaded or myopic in looking at the company's financial presentations. I doubt that they will be any worse or any better in the wake of the LinkedIn transaction.
There are going to be some changes in financial ratios in the wake of the combination. I don't know if Microsoft will choose to go back and provide pro forma results for what the combined company might have looked like in historical periods. That being said, the move from perpetual to annuity revenues is distorting all of the financial metrics of MSFT in any event. From a reporting perspective, little will really change, I believe.
Software companies have and will continue to use stock-based compensation. It is part of how they have done and will continue to do business into the foreseeable future. Microsoft uses far less stock-based comp than does LinkedIn, but in putting the two companies together, the overwhelming difference in size means that looking at that metric in a combined pro forma will not change one's outlook all that much.
Many of the balance sheets in the software world are perhaps a bit unusual in that they have both cash and debt because the cash is not accessible being locked up abroad. That is more a function of the insanely idiotic corporate tax structure in this country, which essentially forces most tech companies to move as much reported profit as possible offshore and keep the attendant cash outside of this country to avoid the draconian statutory tax rates. So Microsoft has $105 billion of cash and $41 billion of debt. That is dysfunctional, but totally normal. LinkedIn has $3.5 billion of cash and $1 billion of convertible notes, partially for the same reason (In the case of LNKD, the notes bear interest at 0.5% and are convertible at $294/share; it is hard to believe that was just 18 months ago).
It is true that some of the financial ratios are going to change somewhat when LinkedIn's results are reported under the Microsoft umbrella. LinkedIn has higher gross margins than Microsoft - it is a pure software company, and MSFT sells a fair amount of hardware. And LinkedIn does have a far greater proportion of its revenues consumed by OpEx than has MSFT. Under GAAP, MSFT will have to exclude all of the deferred revenue that is currently on the LinkedIn balance sheet. At the last reporting period, that totaled $586 million, which is a trivial amount for Microsoft given that its quarterly revenues are $20 billion. Because of the huge difference in size, the change in ratios will not be all that significant.
LinkedIn has been on the cusp of abusing stock-based comp with 17% of revenues falling into that caption. Still, the total amount of stock-based comp last quarter was $146 million. Microsoft's stock-based comp of $672 million was just over 3% of revenue. When the two companies are combined, the stock-based comp ratio will be higher, no doubt, but not consequentially higher.
The one issue that is perhaps going to present problems for some people is in Microsoft's segment reporting. But, then again, a company that has one caption that it calls "More Personal Computing" as a bucket to collect some revenues that flow… well, they flow from PC-related software is not all that transparent in any event.
As I wrote as part of a recent article regarding MSFT, the company's change in reporting segments may have done something to line up the segments with the way MSFT's business is organized, but did nothing at all to help investors understand the trends at the company. Will Microsoft decide to put LinkedIn's revenues in the Productivity and Business Process bucket? I hope not, and the preliminary indications on the conference call are that LinkedIn may well have its own segment. But Microsoft's earnings presentations, while being perfectly standard, have hardly been a model of transparency. They will not be much worse for the inclusion of LinkedIn.
The real issue is whether the price was excessive or not, and here we are going to get back to commenting that the point of view depends on the point of view. I recently wrote a positive article regarding LinkedIn and essentially said it was undervalued. Is $196/share overvalued?
The market is always right is supposed to be a reliable adage. But LinkedIn's share price fell to the $98 level because of a quarter and commentary that were interpreted in a hugely negative fashion and did so in the midst of the tech panic that was underway at that time. Before today, the shares appreciated by 32% from that $98 share price of February 9th, 2016. Over that same span, the IGV index (software tech index) appreciated by 27%. LinkedIn's shares are more volatile than the IGV index. So quite a bit of the overpayment turns out to be nothing more than LinkedIn's shares adjusting to a different market phase.
We could debate the circumstances of the earnings report and more specifically the guidance ad infinitum and reach no objective conclusion. What is true, however, is that the next earnings report was perceived as much better. The market may have thought that LinkedIn's shares were worth $98 at the time, but this is one of those cases in which the exception proves the rule. LinkedIn's shares actually sold at $258 as recently as November 9th of last year. By that standard, MSFT is getting a nice bargain. Shares of momentum IT vendors are volatile, and from time to time, their valuations are divorced from reality. That was true when LinkedIn's shares were $258 and were true when the shares were $98. That kind of analysis really doesn't get to the point as to whether or not this is a good transaction for Microsoft's shareholders.
The other part of the negative case is the comparison of the forecasted non-GAAP P/Es of LinkedIn vs. rivals Facebook (NASDAQ:FB) and Twitter (NYSE:TWTR). Twitter is clearly a troubled company at this point. Whether or not its shares are overvalued depends on the management's ability to turn the ship around. I am not all together sure how much stock ought to be placed on analyst estimates. If it makes its numbers this year, it will have grown by 22%. Analysts have been busy downgrading the shares and revising estimates for most of this year. The shares have lost 40% of their value this year. The relatively lower P/E is function of an imploding share price and not a representation of any sort of bargain valuation.
Needless to say, Facebook is another matter. Facebook does have a higher growth estimate than LinkedIn. And you get an estimated 10% more in earnings per share for shares that are now 42% less expensive than the valuation that is represented by Microsoft's bid. But take a look at the EV/S. For FB, that metric on consensus 2017 estimates is 8.7X. And for LinkedIn at the Microsoft bid price, the EV/S is less than 6X, again on 2017 estimates that haven't seen much change despite the company's strong results in Q1-2016.
Just for the moment, if I may be allowed to publish some heretical thoughts, perhaps MSFT's thought process is that by integrating MSFT's and LNKD's assets, it might create an engine to rival FB's growth rate. I don't think, as I explain below, that is all that far-fetched. Perhaps Microsoft believes that the combination of the two companies might dramatically improve the efficiency of the new revenue streams. I am sure that Mr. Nadella and Mr. Thompson must have spent hours alone and in conference before making the decision to embark on this venture. It can be fun to second guess, but so far, all I have seen is men intent on taking a risk to achieve a transformation. Execution will be key. But the outlines of how this deal will be accretive and not destructive of shareholder values are in view.
How can this merger really work?
Let me start by acknowledging that Microsoft's record on integrating large acquisitions is not peerless to say the least. The best that I can say is that both Messrs Nadella and Thompson know all about failed mergers. They both know that the former CEO of Microsoft was pushed into early retirement because of a list of failed mergers. And, so far as it goes, Mr. Thompson himself was the responsible party behind Symantec's (NASDAQ:SYMC) acquisition of Veritas. So it's reasonably sure that they know what not to do. And every analyst alive and still working knows about Microsoft's sorry record, and as it happened, the first question on the conference call related to just that.
This deal, at least to me, is all about revenue synergies. On the conference call, the CEO called out the synergies he sees in using LinkedIn Recruiter to enhance the Dynamics platform. He talked about how Dynamics can be enhanced by the addition of Sales Navigator and social selling and how Microsoft can use the learning solutions at LinkedIn to build out a robust suite of learning management tools.
Mr. Nadella was at pains to talk of the deal enhancing MSFT's TAM by 58%. I am sure that somewhere there exists a series of calculations and a PowerPoint presentation embodying the assumptions. I always have my doubter's cap on when I see those kinds of numbers. Given the resources, I am sure I could prove that the sun moves around the earth. But whether it is 58% or some other number, either higher or lower, it does seem clear that combination will have a significantly broader scale of opportunities together than it has had separately.
Some of the more obvious opportunities include using the LinkedIn social fabric across all of Microsoft, particularly in Outlook but also in Excel or PowerPoint or Word. For some users, and that includes this writer, using FB like, LinkedIn landing page is something of interest. Office 365 will be able to look quite different and will have more value to some users. Microsoft is also planning to integrate LinkedIn's news feed within its desktop applications. Another potential is providing Microsoft's Cortana digital assistant with the professional data from LinkedIn's profiles, which might enable users to be better prepared for meetings with colleagues and customers. Another opportunity will be to integrate LinkedIn's Recruiter and Talent management with Microsoft's Dynamics HCM and possibly some of the other components in the Dynamics stack (In the interests of space and to avoid being tedious, I will limit any further analysis of potential product synergies between MSFT and LNKD. Suffice to say, there are very many and far more than I could discuss here in any detail. Some will work well, some will have mediocre success, and some will be a bust. Frankly, if only a few are home-runs, it will be more than enough).
I am sure that some of these ideas will never reach the scale that must have been projected by the deal makers. It is unnecessary that they do so. But can the sum of a few of these opportunities and other unknown and unquantified opportunities increase LinkedIn's growth rate from 20% to 30% or 40% for some years to come? I think it is a reasonable bet and is more than enough to justify the transaction.
In addition, the companies have identified $150 million in annual cost savings most likely as a product of downsizing LinkedIn's G&A as part of the combination process. The $150 million is more or less a rounding error; one might assume that at some point, the cost synergies will become a bit more significant, primarily in terms of the sales effort. Both companies already have enterprise sales strategies, and of course, enterprise sales forces, and I think that some combination of those two efforts is more or less inevitable.
Readers may notice that I haven't written anything till now about potential dilution from this transaction. That is mainly because there is so little. CFO Amy Hood is forecasting about 1% dilution for about 18 months using the current LinkedIn revenue consensus. Ms. Hood has been a decent CFO in terms of her communications with the financial community - well, other than the business segment presentation. Microsoft has missed at times during her tenure, but the misses have had more to do with the inability of many to have forecasted the scope of the PC sales slowdown and how it might impact Microsoft.
1% dilution is more or less a rounding error for a company of this size. And the fact is that LinkedIn will be just more than 4% of the revenues and the costs of the newly combined company. Dilution isn't the issue, it is accelerating MSFT's revenue growth, which has been basically non-existent for two years, and attempting to use sales synergies as the lever to improve the growth rate.
All acquisitions have their risks. But, in this transaction, based on the available evidence, it appears that there are more potential rewards than there are potential risks. That "high" valuation for LinkedIn that Microsoft has agreed to pay simply doesn't look that high to this writer when considering the many, many opportunities there will be for accretion and for sales synergies.
A final comment before I sum up. One commentator on the site talked about the likelihood that MSFT's dividend increases might be curtailed as it tries to refresh its cash balances. I would have a hard time disagreeing with that assessment. This transaction was not consummated for the sake of dividend increases; it was consummated to reignite absent growth. The CFO did talk about the company's capital return program and the required cash balances to run the business. Net is that some components of the cash return program will continue, and that net of the $26 billion, there is still adequate cash to run the business. But I imagine that whatever dividend increase might have been heretofore contemplated will be muted in the wake of this transaction.
This transaction is meant to be transformational and it certainly has that potential. Some key points as I see them:
- I believe that LinkedIn was one of the few opportunities of some scale available for Microsoft to purchase which would lead to visibly higher cloud revenues. It has the advantage of being affordable to Microsoft's cash balances, and that has little overlap, so that it will be approved by the authorities.
- While the premium MSFT is paying is no doubt large, it can, I believe, be justified by the long list of potential revenue synergies and to a lesser extent by cost synergies beyond those currently forecast by management.
- The architects of this deal from the Microsoft side are both very familiar with failed mergers and are at the least familiar with the career impacts that are likely from a transaction that fails.
- Management spoke to a 58% expansion of the TAM of the combined organization. Whether that number is high or low, it is apparent that it is significant and is part of the basis that underlies the valuation of LinkedIn that Microsoft was willing to pay.
- The company has forecast limited dilution from the transaction using reasonably conservative assumptions. The dilution forecast is actually so visible that it will not be visible to the naked eye. The accretion potential is far more significant.
- There appears to be limited financial risk in this transaction. While the deal is meant to be transformative, LinkedIn will represent just 4% of the revenues of the combined company. Besides eliminating the duplicative efforts of running two public companies, there are likely further cost synergies in putting together two enterprise sales forces.
- It is, at this point, almost impossible to even begin to handicap the potential amount of revenue synergies that might be created. And it is even more difficult without revenue estimates to guess the potential EPS accretion. I ran some highly speculative horseback guesses, and I think the potential is that, over time, the transaction may add $1.5 billion to after tax net. There are lots and lots of assumptions that are more guesses than anything else, and some of those assumptions might be tendentious to some. But, if $1.5 billion is a decent "guesstimate" of the after tax accretion after 4-5 years, it would raise MSFT's EPS by 6-7% of the likely earnings currently forecast. And, of course, it will also raise the company's revenue growth rate albeit by some small percentage. For most investors, this is definitely a deal worth doing.
- For that cohort of investors that owns MSFT's shares for their dividend and the potential yearly increase, this transaction will not be viewed with favor. The company has a current yield of 2.8%. That is not at risk. But the size of the next dividend increase is likely to be constrained by the spending of $26 billion in cash to buy LinkedIn.
Mergers are risky to be sure, and MSFT has had more than its share of misfires. It appears, however, that management has carefully considered the risks and is well aware of the potential consequences to its own employment security if this transaction is not successful. There is far more upside in this transaction than there is risk that it will destroy shareholder value.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in MSFT over the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.