Last week Microsoft announced its intention to buy LinkedIn for a total consideration of $26bn. This is a big move, even bigger than the $22bn acquisition of Whatsapp by Facebook in 2014. The reason why I did not write earlier about it is that I was trying to understand the move. After a week thinking about it, I just cannot.
Well, for LinkedIn’s shareholders, the deal is hard to refuse: LinkedIn’s share price has been suffering since the beginning of the year as the market has become increasingly sceptical about the social network’s sustainable future growth rate. Worse, fundamental shortcomings have become more numerous and obvious: low user engagement (less than 25% of users connect more than once a month), unclear purpose (from networking the firm entered business news and professional education), struggling profitability (despite $3.2bn in sales, the company reported a negative net income of -$170m last year) penalised by low ad revenues (6 times lower than the ones generated by Facebook in the US) and a raising dependence on professional services as opposed to individuals (‘talent solutions’ now account for c.65% of the firm’s revenues, which will soon have a hard time justifying its ‘social network’ primary status). Microsoft’s offer, at a 50% premium over the pre-announcement share price, represents a godsend in that respect.
To justify this high price, Microsoft mentioned the competitive tension generated by the presence of Salesforce. One can never predict in advance how well an integration will work and to which extent synergies would have been delivered, but such a merger would have made more sense: the two firms serve the same purpose – i.e. connecting professionals, either individuals, marketers, recruiters or headhunters, in order to create business opportunities – and LinkedIn already integrates Salesforce’s Sales Navigator product. To close the loop, Microsoft made a $55bn offer for Salesforce last year, which was perceived as too low by the target’s Board of Directors.
In terms of valuation, LinkedIn’s forward PE ratio is one of the largest of the ‘web 2.0’ industry, only second to Yahoo! in the sample chosen below. This fact was true even before Microsoft made a move towards the ailing social network. Unfortunately, a forward PE ratio in the 40x+ area is a sign of perceived overvaluation, even for a tech firm – former holders of Yahoo! shares may not disagree on that one.
This deal is also haunted by Microsoft’s appalling track record in handling and integrating large acquisitions. Experts obviously have in mind the disastrous acquisition Microsoft did in 2014 when it acquired Nokia’s ‘Devices and Services’ business for $7.3bn before writing-off almost the entirety of the acquisition assets less than 18 months later. At best, the Redmond firm managed to maintain a ‘status quo’, as it has done with Skype since 2011 – and questions about the rationale were already present at the time. As a consequence, Microsoft’s share price reacted negatively following the announcement – only a 2.6% drop, which nevertheless still represents $10.5bn of lost shareholder value.
So why such an unexpected alliance? In terms of synergies, the pitch is not obvious either. Jeff Weiner, LinkedIn’s CEO, mentions in his email to staff that the deal will “massively [scale] the reach and engagement of LinkedIn by using the network to power the social and identity of Microsoft’s ecosystem of over one billion customers”. Not sure what that means beyond having Outlook download data from LinkedIn to give you information on people you will meet. More generally, and contrary to what the Financial Times may think, I doubt that Microsoft’s products, which are targeted at enhancing the work efficiency within organisations, will be able to gain much insight from LinkedIn’s vast amount of outside-in data.
Alternative hypothesis: is Microsoft betting on internal corporate networks? In-house social networks are indeed becoming increasingly trendy. Even McKinsey believes that social tools will help reshape the way businesses work in a number of ways – see chart below. But internal social networks struggle to gain momentum and more importantly LinkedIn is not one of those. Indeed, the tool is well designed to search for individuals working for a particular firm, but it is unable to tell you how the firm is internally structured.
Another possibility is that Microsoft is trying to add content on top of its software offer. Social networks now represent the primary source of information for more than half of all online news consumers, and this trend comes with interesting ad revenues prospects attached. But LinkedIn is trailing Facebook or Youtube in that respect.
For me, the move was launched primarily to manage market perception. Microsoft is currently sitting on more than $100bn of cash & equivalents. This war chest cannot sit unused within the company for ever. There are only 3 solutions to that conundrum. One, Microsoft could pay hefty dividends as Apple did. The issue is that it would admit (as already highlighted on this blog) that Microsoft is running out of worthwhile investment opportunities. This is fine when you are Apple and sitting on hit products such as the iPhone, but much more worrying when you are Microsoft and holding onto an ageing operating system. Two, Microsoft could buy back some of its shares but this move would be uselessly expensive given that Microsoft’s shares trade near all-time highs. Three, Microsoft could pretend it is moving full steam ahead towards cloud computing, artificial intelligence and professional networking by making acquisitions. This is the path Satya Nadella and his team have chosen, a path similar to the one Marissa Mayer unsuccessfully led Yahoo! to, but targets in the space are scarce and, as the saying goes, “anything scarce should become expensive”. To make the bill more palatable, the acquisition is partly financed through debt which, given Microsoft’s AAA rating, represents a net cost savings – the tax shield amount more than largely offsetting the incremental debt interest costs.
Although spectacular by its size, this acquisition strategy is not unique. Tech behemoths ‘of the past’ see that, after more than a decade of steady and healthy cash flows, the new wave of innovators, led by Facebook, Google and a tribe of unicorns, can in the relatively short-term jeopardise their business model. To fight against the new entrants, they cannot rely on their in-house innovation skills, which have aged together with the rest of the organisation. In a (final?) burst, they are now spreading their cash, hoping they will manage to integrate the right engines for future growth – think about Blackberry and its push in cybersecurity for instance. Massive war chests, overvalued (tech) stocks, cheap debt, ageing organisations: the perfect recipe for disaster and value destruction, sadly.