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.
H.M. Payson & Co.