Introduction - focus on strategy
This is my third article on tech's large cap lead horseman of the day, Microsoft (MSFT).
The several Seeking Alpha articles on MSFT that followed its Q3 earnings release make the basic points well: MSFT is firing on all cylinders. I peg its 12-month forward EPS at $5, putting the forward P/E around 25X. Given my projection of a 5-year CAGR of 14%, that puts the P/E/G below 2X, which is low for this market (SPY). So I'm comfortable with MSFT as a rock-solid company with a relatively attractive valuation. Because the components of its current performance and possible rapid growth have been discussed so well, I'm going to focus on just one part of MSFT, namely LinkedIn, or LI. I enjoyed and learned a lot from this sort of detailed discussion on individual parts of Apple (AAPL) on the Braeburn Forum when I was a moderator there, back in 2012. I hope this sort of article on MSFT and LI is worth your while to read, and I look forward to being educated from any comments you choose to share.
In 2016, MSFT won what reportedly was a competition against Salesforce (CRM) to buy LI, paying $26 B. Many wondered about this deal. How did it make sense for MSFT?
Now, less than three years after the deal was completed, I like this deal a lot, for the following reasons.
A window into Nadella's thinking, from 2015
First up is a diagram from a GeekWire article, titled Microsoft exec: Why Apple and Google have an advantage, and how Microsoft plans to compete:
The diagram, from an MSFT presentation, was explained this way:
The relative size of the circles indicates the number of users during the window of time that Microsoft conducted the study. The lines indicate when users of one product are more likely to use another.
So, it describes ecosystem strength; MSFT wanted to improve. Part of my thinking is that the LI deal was done in part to strengthen MSFT's entire ecosystem.
Within the GeekWire article is a link to a transcript of lengthy remarks from Chris Capossela, MSFT's chief marketing officer. In it, he describes the One Microsoft logo and theme, and references ways that Microsoft was now in essence co-marketing one product along with another. Referring both to AAPL and Alphabet (NASDAQ:GOOG) (GOOGL) per the graphic shown, and MSFT's weakness in having a disjointed ecosystem, and also noting Cloud leader Amazon's (AMZN) AWS, Capossela says near the end of his talk that:
No. 1, we know consumers are choosing an ecosystem more than ever. They might buy one device at a time, but as soon as they buy a device they’re getting pulled into an Apple ecosystem, or an Android ecosystem, or a Windows or Microsoft ecosystem. And No. 2, on the commercial side CIOs and business decision-makers tell us they don’t really want to move to the cloud with a single product. They want to move to the cloud with a partner. They’re going to bet on Microsoft, or on Amazon or on Google to move to the cloud, IBM, what-have-you. So that both of those trends tend to make us want to lean more to the Microsoft brand itself.
We also have found that the [Microsoft] brand is just incredibly strong...
That Capossela repeated ecosystem so many times could be telling.
Then, within about a year later, MFST engaged in serious talks with LI.
The following sections summarize some of the potential ecosystem benefits that LI could bring to MSFT, and that MSFT could bring to LI.
LI is ideal for cross-selling
A smallish stand-alone company, LI had to fight hard to grow. As part of MSFT - a business-oriented company and therefore a job-oriented company - LI can promote MSFT products to its users (especially businesses but also job-seekers).
In the reverse direction, MSFT can refer its hundreds of millions of customers to LI. What could be easier than offering discounted or temporarily free trial on LI to a Dynamics 365 user that is not active on LI? Or pitching Teams to businesses active on LI, or products geared to individuals to appropriate job-seekers? Not that MSFT is necessarily doing these things now, and of course other tie-ins are available, but the opportunity is there in various ways.
The same reasoning goes for educational software, which LI obtained via the Lynda.com deal and which remains with LI.
There are not a lot of synergistic deals, but the LI deal may be an exception.
LI works well with MSFT's growing AI capabilities
The amount of data generated on LI is immense, and is growing steadily. How can LI dominate its field going forward as Facebook (FB) and others try to compete with it? Beyond known network effects, AI is one important way to go.
MSFT's growing AI capabilities may let LI extend its lead as the leading global web site for jobs and related fields such as education. How to show different users of the site different content and prioritized suggestions is likely to be big in the coming decade. I think AI is going to be needed to make this sort of personalization be a win-win for the companies that do it and their clientele.
It also may be that going through this process with the large amount of data that LI generates will allow MSFT to improve its AI capabilities, which would improve its operations.
Next, a possible growth theme for LI.
LI's potential challenge to FB
While FB wants to compete with LI, the challenge could be mutual. The LinkedIn.com main web page shows "Welcome to your professional community" first. But, scroll down just a bit and you see:
Join your colleagues, classmates, and friends on LinkedIn.
Hmmm... that's FB territory.
Perhaps LI can actually gain some share from FB (and Snap (SNAP), etc.) in social media.
One reason to be optimistic is that FB has truly immense operating margins. If a business is large enough, competition generally forces very high margins lower.
E-Trade shows EBITDA margins of 52% for FB and 43% for MSFT. Thus, there is a ton of low-hanging fruit (profit) for MSFT/LI to pluck over time. Clicking on LI's "get started" button provides the option to either sign in via one's LI sign-in, become an LI member, or use one's FB sign-in. Might the FB option be dropped someday?
LinkedIn Social, anyone? (Or, continuing the One Microsoft theme, Microsoft Social?)
I can think of various ways that LI could incentivize its user base to shift at least partly from FB, especially for more business-related yet "social" matters, and in time, gain share of time spent on the site at the expense of FB.
For MSFT, an adjacency such as an LI Social may represent a low-cost, low-risk, potentially high-return way to advance the MSFT cause. Other possibilities in this vein exist.
How big can LI get?
LI's revenues for Q3 were $1.70 B, up 27% yoy and up 29% in constant currency (p. 32 of the 10-Q). Given these growth rates, if LI is just now hitting its stride, I'm going to project a $10 B run rate by the end of FY 2021, i.e. in a little more than two years. That would make it much smaller than FB, with projected revenues at a $90+ B run rate at the same time, and it would only represent about 7% of MSFT's projected FY 2021 revenues of $154 B (projections from ETrade).
I see no clear limit to LI's growth potential. In the hands of Team Nadella, I suspect that it will find several ways to advance its core business and add one or more profitable adjacencies.
Rather than discuss a laundry list of details, it's time to sum up.
Conclusion - LI as both a promising addition to MSFT and an example of a CEO with strategic vision
This article makes two major points.
The first is the thought that Satya Nadella was willing to spend $26 B for LinkedIn not just because someday it could generate enough profits to justify the expenditure, but also because of its strategic value to MSFT as a whole. Many LI users come from the AAPL or GOOGL ecosystems, and using LI as part of MSFT provides MSFT a chance to get them to look at doing more with MSFT's products. On the business side, engagement with LI gives MSFT several ways to generate additional business for its several well-known, core Internet-based product categories.
Assuming that the above point is valid - and only Softee knows for sure - then it would represent an intriguing, different way to think of an ecosystem. Linear thinking might have led to acquiring a large cybersecurity player or a large software/Internet company, and calling that an ecosystem strengthener. The nature of LI is different from the rest of MSFT, but I think it will strengthen MSFT's ecosystem.
The second point is that LI appears to be succeeding very nicely, without considering the rest of MSFT. If growth does not slow a lot, by 2022, LI could be generating similar revenues as FB did in 2014 ($12.5 B). FB's valuation was around $200 B by Q4 2014. Who knows what LI's intrinsic value might really end up being in the early years of the next decade?
In summary, I believe that LI could, in a few years, be a noteworthy enough sales and profit center - with significant future growth potential - to contribute materially to MSFT's valuation, using a sum-of-the-parts method. I also believe that MSFT was trying to strengthen its ecosystem in doing this deal, and may well be succeeding in that front. My conclusion is that a deal that could have been a loser now looks like a testament to a brilliant MSFT management, as well as great execution within the LI team.
A final comment about MSFT:
One year ago, I wrote Microsoft 3.0: A Turnaround That Looks Real, followed in July by Microsoft: Letting This Bull Rampage On. Both those headlines express my point of view now, even with the stock having closed Tuesday at $127.67, up about 30% yoy. It is unusual for a company MSFT's size to be growing so fast while appearing to retain double-digit growth potential for at least the new several years. I think the premium MSFT valuation at this time of low competing interest rates and generally high P/Es for companies with less going for them at the present time can in my view be easily sustained.
The more I see MSFT as a whole, and of LI's progress, the more I think this company is on quite a roll. No guarantees exist, but so far, so good.
Thanks for reading and sharing any thoughts and knowledge of MSFT, LI and other competing companies and stocks you may wish to contribute.
Disclosure: I am/we are long MSFT,SPY. 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.
Additional disclosure: Not investment advice. I am not an investment adviser.