I was going to post this article earlier, but I am glad I waited a bit. Since, there were thousands of articles writen about the acquisition this article would have been drowned out in the chorus. However, now the media has moved on to more exciting news like the scandal with the IMF chief, which I am proud to announce I have not read one article about.
Without further to do:
Microsoft has recently made headlines with the news of acquisition of Skype with a hefty $8.5 billion price tag, which is the largest acquisition made by Microsoft until now. It can be undeniably stated that Microsoft has undertaken various successful strategic decisions over the past few decades and has produced numerous superior products (Windows, Xbox and MS Office) which has deep market penetration and loyal customer base. However, their acquisitions have been almost without fail, disastrous. Their bid for Yahoo, which thankfully (for Microsoft) failed was just an example of bad management.
Microsoft was founded by Bill Gates in 1975 and since then, it has been one of the most successful companies in the world. Today, the market cap is over $200 billion. Microsoft has a long line of products. Microsoft develops, licenses, and manufactures an extensively diversified range of products and services, under various business segments which include Windows & Windows Live segment (Windows operating system, Windows Live and Internet Explorer), Server and Tools segment (Microsoft SQL Server, SQL Azure, Silverlight, Visual Studio, etc), Online Service Division segment (MSN portal and Bing), Microsoft Business Division (Microsoft Office, Microsoft Dynamics ERP and CRM, etc), and lastly Entertainment and Devices Division segment (Windows Phone, Xbox 360 platform, PC software, etc). Microsoft currently has approximately 90 million business customers, 400 million Windows Live users, and more than a billion Windows operating system users worldwide. A few years ago, bears mentioned that google documents, which are free, would make office obsolete; right now google docs have 1% of the market share. Other free types of Microsoft office have failed to dent Microsoft’s lead in office. In regards to operating systems; bears said that pirating, and free operating systems would destroy Windows. Despite, the disaster of Windows Vista, Microsoft has shown great success in Windows 7, which has sold 350 million copies to date.
In 2009 and 2008, Microsoft’s Business and Windows Divisions reported high operating profits of $12.1 billion and $10.86 billion respectively the same year.
Despite Microsoft’s hold as a leading company in various market segments, it faces high competition from Apple and Google. Zune, Microsoft’s portable music device, has almost no market share compared to the ipod. Google is still by far the most important, and largest search engine. Microsoft also has almost no precesne in the growing smart phone market, with Google, RIMM and Apple dominating it . Additionally, the ipad is the biggest player in tablets, and Microsoft would have a lot of catching up to do.
However, Microsoft is trading at 7x earnings net of cash. Including the dividend of 2.58%, that is a 17% yield! The company, once a high flier tech bubble stock, is now being abandoned by most investors. Despite, intense competition Microsoft is operating well and seems absurdly cheap.
Although, Microsoft faces challenges they have dominance in many areas and their earnings and revenue continue to increase. Warren Buffett recently stated that he would buy Microsoft if not for Bill Gates being on the Board of Directors. Even though Buffett has strayed from being a pure Benjamin Graham investor, Buffett hates tech. He has said that he likes google’s business model. However, Microsoft was the first tech company that Buffett ever mentioned he wanted to buy (although, it can be argued BYD is tech, but that was more of a Charlie Munger decision). It should be noted though that Buffett made these comments right before the Skype transaction.
These above mentioned facts lead us back to the topic of Microsoft’s recent acquisition of Skype. There has been extensive stakeholder inquisition regarding the acquisition, which cost Microsoft approximately $8.5 billion. According to H.M. Payson & Co., under the assumption of Skype’s revenue growing at 20% while maintaining a profit margin of 30% and assuming 12% as cost of equity, the intrinsic value of Skype turns out to be $4.5 billion. Furthermore, its intrinsic value is calculated to be $8.2 billion with 10% cost of equity and $6 billion with 11% cost of equity. The aggressive assumptions made by H.M. Payson & Co. in order to justify the purchase of Skype, undeniably paint a worrisome picture for the value of Microsoft’s stockholder.
Another, amazing analysis was done by NYU Stern Professor of Finance, Aswath Damodaran. This is the best article I have seen about Skypes valuation from the ~1 million articles that I read on the topic. I strongly encourage readers interested in the topic to read the full article.
Here is a chart from the article:
There has been extensive stalk about what Microsoft should do with its $44 billion of cash, which only continues to accumulate every day. In a recent Q&A with Steve Ballmer, CEO of Microsoft and Tony Bates, CEO of Skype , there was no reference of shareholder’s value, expect for one time where shareholders are mentioned in context of Skype being a beneficial option for Microsoft by utilizing the overseas cash balance for purchase. There was absolutely no mention of valuation.
Without proper disclosure of information regarding the benefits of the acquisition to stakeholders and the resultant increase in the value of the shares held by the stakeholders, the announcement demonstrates nothing but severe lack of respect of the shareholders by Microsoft.
David Einhorn stated this past Wednesday, that CEO Steve Ballmer needs to go. While, I am not running one of the largest companies in the most competitive, I would have to agree with Einhorn. Despite, Skype being a realitvely small transaction in relation to both Microsoft’s large market cap, and cash holdings; the transaction demonstrates that Ballmer is a value destroyer and not a value creator.
Although, I still believe Microsoft is cheap, I cannot buy a company where it seems management has no idea what to do next. The cash cannot be paid out in the form of a higher dividend without a tax penalty since most of the cash is parked overseas. However, this is far preferable than absurd acquistions.
One tennet of value investing is to be patient. Although, I might miss out on a great opportunity, I would rather do so then trust my money to the current management. That is why I sold my shares of Microsoft right after the acquistion of Skype was announced.
Disclosure: I currently have no position in Microsoft