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Reevaluating Microsoft Holdings After Skype Deal

May 13, 2011 | About:
Ben Michaud

Ben Michaud

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At H.M. Payson & Co., we believe Microsoft’s proposed purchase of the internet communications company Skype, announced May 10, 2011, requires considerable attention.

While we do not pretend to have an advanced opinion regarding the long-term economic prospects of the technology industry, we believe that at less than 10X forward earnings, an investment in Microsoft is warranted based on the thesis that the economic moat surrounding Microsoft’s Windows & Windows Live and Microsoft Business segments (both segments generate a combined $23.6 billion of pre-tax earnings, or 98% of consolidated pre-tax earnings) will remain strong for longer than the marketplace is currently anticipating (as evidenced by the no-growth multiple assigned to the stock). We also believe (or believed) that a decade-long stagnant stock price would afford management the motivation to boost the stock via a debt-financed buyback or special dividend, a spin-off, or a change in management.

At a tax-adjusted price of $5.95 billion (assuming a 30% repatriation tax rate), or ~12% of Microsoft’s cash balance as of 3/31/11, the purchase price Microsoft is paying for Skype does not call into question our thesis regarding Microsoft’s economic moat. However, at 7X revenue and 22X EBITDA with zero accompanying statement(s) by Microsoft executives or a shareholder presentation detailing how the transaction is accretive to shareholder value, we believe the transaction demonstrates a severe lack of respect for Microsoft shareholders. The Skype purchase may in fact have the highest NPV of any project in Microsoft’s history, but without that fact spelled out in a clear and concise manner, shareholders are at the mercy of management’s judgment.

The following quotes are from the press releases for two unrelated, publicly announced transactions in 2011 by Sara Lee Corp and ConAgra, respectively. The quotes are presented as a demonstration of the great length most companies go to in order to appease shareholder anxiety regarding large capital allocation decisions.

1. “Sara Lee Corp announced today that its board of directors has agreed in principle to divide the company into two separate, publicly traded companies…Each company will have leading consumer brands, compelling growth prospects and strong potential to deliver long-term value to shareholders.” (1st paragraph of the press release)

2. “ We believe this all-cash proposal is highly attractive to Ralcorp’s shareholders and a transformational growth opportunity for both companies.” (1st quoted statement by the ConAgra CEO in the press release)

In stark contrast to the above-mentioned press releases, the press release announcing Microsoft’s definitive agreement to purchase Skype was entirely devoid of the terms “shareholder” and “value”. In the 9-page transcript of the Q&A session involving Microsoft CEO Steve Ballmer and Skype CEO Tony Bates on the day of the announcement, the word “shareholder” is mentioned once in reference to how utilizing overseas cash balances to purchase the Luxembourg-based Skype is beneficial to shareholders, and the word “value” is mentioned nine times in the context of creating customer value.

Due to the lack of management disclosure regarding the merits of the Skype acquisition, as shareholders, we are forced to ascertain how effectively our capital is being deployed based on the announced details. Skype generated $860 million of revenue in 2010 and is estimated to be growing at 20% per annum. Assuming Skype generates Microsoft-level net profit margins of 30%, estimated distributable cash flow in 2011 would be $310 million. For our back-of-the-napkin valuation analysis, let’s assume Skype will grow revenue at 20% per annum for ten years while maintaining 30% net profit margins, and that starting in year 11 (2021) Skype becomes a mature company paying out 50% of its earnings and growing with GDP of 6%. Utilizing a 12% cost of equity to discount Skype’s terminal value at FYE 2020 back to today, the intrinsic value of Skype under those assumptions is $4.5 billion. Utilizing a 10% cost of equity with the same assumptions in place, the intrinsic value of Skype is $8.2 billion. Splitting the difference and using an 11% cost of equity, the intrinsic value of Skype is $6 billion, or slightly higher than the $5.95 billion paid by Microsoft. This exercise is not meant to derive an intrinsic value of Skype, but rather to demonstrate the aggressive assumptions needed to justify purchasing Skype, a business with no readily apparent economic moat, for 7X revenue. In the long-run, even Apple-like growth will eventually falter, rendering a business’s terminal value helpless to the predictable vagaries of competition.

As Microsoft shareholders and the rightful owner to our portion of the $5.95 billion spent on acquiring Skype, we believe that we, along with every single other Microsoft shareholder, deserve a detailed explanation as to why the Skype purchase was more beneficial to our wealth than a $.71 per share special dividend worth 2.7% of the May 9th closing price of $25.83. Without an explanation, we will have no choice but to assume this transaction is indicative of management’s approach to deploying our capital, and thus will be forced to conclude that Microsoft is no longer a prudent holding for our clients.

Fellow Microsoft shareholders, join us in demanding an explanation.

Ben Michaud

Research Department

H.M. Payson & Co.

Rating: 4.4/5 (32 votes)

Comments

Alex Morris
Alex Morris - 2 years ago
Fantastic article; as I said in an article the day the deal was announced, "With the Skype deal, I'm left to value eyeballs, synergies and future expectations – three things I'm decidedly poor at deciphering or putting a number on. In the end, management better present a pretty convincing argument for why Skype, and why now." The questions are still unanswered...
nmadhukar
Nmadhukar - 2 years ago
Agree with what has all been said and completely agree that MSFT paid a higher price for Skype. But however, when it comes to technology company, I do not think a pure discount model does not really help. Some quick questions on above valuation?

1. What about the added value skype brings to Kinect & other gaming consoles for multiplayer platform.

2. Added value in terms of user base for msft, plus for the mobile segment

3. What abt MSFT saving the tax on money overseas.. MSFT had to pay tax to Uncle sam has it brought back the money to US... so thats a 20% saving right there...

4. When Google bought youtube for 1 billion, the same industry pundits criticized it, & Youtube is yet to make profits for google todate.., does that mean in the past 5 to 7 yrs the value of youtube depreciated?,, I guess anyone would jump on the board to buy it for 10billion today...

soaringmu
Soaringmu - 2 years ago
I certainly agree that MSFT just wasted a pile of money. Buying Skype may make sense, but at that price it is madness.

However, I don't think the comparison to the Sara Lee statement makes sense. It doesn't say anything beyond basically saying "We think it's a good idea." Well, obviously they do, otherwise they wouldn't have done the deal.

And by the way: The standard practice would be for Ballmer to give a presentation about how Skype's revenues will skyrocket and the astronomical synergies they will generate. Would that make matters any better? I don't think so.

Still, I am very worried about capital allocation, too. I hope Ballmer doesn't start doing acquisitions like this.

tkervin
Tkervin - 2 years ago
The long term question is whether Skype will be a YouTube or a MySpace, AOL, Netscape. My view is that this is a lot of money to spend on a service that may not be relevant in a short time.
mikewen
Mikewen - 2 years ago
Exactly!

It does not make sense to use pure discount model to value a strategic assets.

Back in early days of Microsoft, should they buy DOS ?



Agree with what has all been said and completely agree that MSFT paid a higher price for Skype. But however, when it comes to technology company, I do not think a pure discount model does not really help. Some quick questions on above valuation?

1. What about the added value skype brings to Kinect & other gaming consoles for multiplayer platform.

2. Added value in terms of user base for msft, plus for the mobile segment

3. What abt MSFT saving the tax on money overseas.. MSFT had to pay tax to Uncle sam has it brought back the money to US... so thats a 20% saving right there...

4. When Google bought youtube for 1 billion, the same industry pundits criticized it, & Youtube is yet to make profits for google todate.., does that mean in the past 5 to 7 yrs the value of youtube depreciated?,, I guess anyone would jump on the board to buy it for 10billion today...
aagold
Aagold premium member - 2 years ago


I would agree that paying $8.5B for Skype appears to be absolutely nuts. What I can't understand is, why would Ballmer and Gates be so willing to waste their *own* money on something like this? They're not just wasting other people's money, they're wasting their own. I just don't get it. Maybe their judgement is clouded by the fact that they founded MSFT and are thinking emotionally about "thir baby" rather than in their own rational self-interest?
bmichaud758
Bmichaud758 - 2 years ago
"This exercise is not meant to derive an intrinsic value of Skype, but rather to demonstrate the aggressive assumptions needed to justify purchasing Skype, a business with no readily apparent economic moat, for 7X revenue. In the long-run, even Apple-like growth will eventually falter, rendering a business’s terminal value helpless to the predictable vagaries of competition."

Any of the above questions regarding valuation are irrelevant to the point of the article. Management made no attempt to justify the transaction to shareholders in terms of enhancing shareholder value. No matter if you're buying a tech company or your neighbors' bag of sugar, it all comes down to how much cash can come out of the business and what price you pay for it. No matter what form that cash takes - whether it's tying Skype into MSFT products and raising the prices on those products to generate a ROIC, or building Skype into a cash-generating business on its own, management must justify to shareholders how it will enhance shareholder value. Skype may be the greatest asset MSFT will ever purchase, but they did not justify it to shareholder in any way shape or form.

Ben Michaud
bmichaud758
Bmichaud758 - 2 years ago
For those curious about the taxes, please see the first sentence in paragraph #3:

"At a tax-adjusted price of $5.95 billion (assuming a 30% repatriation tax rate)..."

Ben Michaud
Toddius
Toddius - 2 years ago
I agree with basically every point made in the article. One contribution/counterpoint. The company at least suggested that one of the synergies is MSFT's existing network of advertisers. Skype does not currently run ads. I don't know what the projected revenue of adding advertising to the Skype equation would be - but I would bet that MSFT's projections include revenue from this source.

Since I'm long MSFT, I'm hoping it turns out well.
AlbertaSunwapta
AlbertaSunwapta - 2 years ago
I didn't understand eBays' purchase of Skype and I don't understand MSFT's purchase - though I assume MSFT knows what it is doing.

I'd hope they see a need for a unified communications hub combining sight and sound / eyes, ears mouth (texting, emailing, twittering, facebooking, et. al. plus good old voice calling) into a single user service.

With cash burning a hole in their foreign accounts, MSFT could now go back and - to open arms - it could offer to buy YAHOO for a far, far lower price but it isn't. Moreover, it could have done the same with Skype a few years ago when it was sold off.

So what has changed on those fronts? Was the Yahoo buyout deemed foolish after all? Or if Yahoo only had value to MSFT at that point in time - is Skype the same today? i.e. some immediate and pressing need for the technology or eye balls or whatever but something which has very rapidly diminishing value?

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