- Microsoft has been under the scrutiny of investors lately.
- However, the company’s recent steps to unify the platform have positive implications.
- The recent acquisition of LinkedIn also adds much needed strategic value.
Going into Microsoft Corporation's (NSDQ:MSFT) quarterly earnings announcement, I’m gaining a little more conviction given near-term growth drivers post the acquisition of LinkedIn, on-going cloud revenue ramp, gross margin acceleration from annuity ARR (annually recurring revenue) streams. I believe some of the media pundits have yet again miss-characterized the recent acquisition of LinkedIn with the proverbial bean counting therapy that value investors use to massage the nerves of growth oriented analysts/investors.
That being the case, I’m providing my financial model preview in a separate article, so please refer to that as well.
I believe the emphasis on “cloud” is more accurate in Nadella’s management campaign of “mobile-first and cloud-first world.” Initially, the thought process on Microsoft’s approach to mobile was to acquire consumers in the commodity hardware segments for mobile devices. But, given the tepid interest from mobile OEMs and on-going penetration of Android devices globally, the strategy quickly shifted to Microsoft’s software suite being made available across all platforms, inclusive of mobile. This shift implies that Microsoft is happy with its position as a PC/Datacenter platform provider, but will also provide its services on a recurring license model across all devices in the enterprise/consumer space.
Clearing the misconceptions of gaming
Also, there’s the on-going speculation of a potential spin-off of the gaming division/business unit. I find this unlikely given the lack of historical precedence for spin-offs, and on-going speculation of buy side managers likely fueling the rumor mill this time around. Of course, I can acknowledge that the Xbox gaming unit has been a disappointment in the current console generation, but given the favorable drop-off in pricing of Xbox units, and healthy unit growth estimates, I believe the Xbox installed base is reaching that key inflection point where it will exhibit enough strength to maintain its viability among the platforms Microsoft is currently pursuing. Losing the living room reduces Microsoft’s scope and scale among the various device categories. Given Microsoft’s platform-centric approach, there’s no innate advantage to spinning-off the Xbox business, as it helps to maximize its presence in living rooms.
In fact, project Helix is implicit of Microsoft’s intention to create an open Windows platform across all devices. One Windows is the pathway that creates unity for the separate walled gardens between PC gaming and Xbox. Given the loss of market share to Sony in the past cycle and shifting sentiment among enthusiast gamers, Microsoft is likely to create a unified game library across Xbox and PC, which is unprecedented in the history of gaming. We all saw evidence of this at the E3 2016 Conference.
Furthermore, this advantage will reassert the company’s dominance in the console gaming space as the PC installed base is substantially larger than the current generation installed base of both Sony and Nintendo combined. I don’t have numbers off the top of my head, but I anticipate that enthusiast PC gamers exceed 100 million (when based off of my prior Nvidia analysis), and the Xbox One gamer base is likely in the range of 20 million to 30 million currently.
The combined size of the two gamer bases will dwarf the competing platforms and create an opportunity to cross-sell Xbox live subscriptions to PC enthusiasts for Xbox multiplayer titles. Furthermore, it provides the Steam game library for Xbox gamers, which opens Xbox to some of the larger PC exclusive titles further diminishing the risk of content selection when compared to competing ecosystems. With a unified platform for Xbox/PC content, Microsoft can sway the opinions of developers to create more exclusive content. This becomes crucial as the installed base for VR is minimal, and gaining the support of major game developers is crucial for Microsoft’s long-term viability in VR. Furthermore, I anticipate eventual integration and support from Oculus and HTC Vive for Xbox Scorpio.
Understanding the logic behind the LinkedIn acquisition
I think the speculation among public media pundits has reached dizzying heights. I mean, some have claimed that Microsoft didn’t do enough due diligence prior to the acquisition. Here’s the most egregious examples from a well-known content mill of amateur authors.
Here’s what the “Traveling Investor” mentioned in his most recent article. The fact that he hides behind a pseudonym demonstrate little conviction in his stance. Here’s what he mentioned:
We know that the acquisition was not a preconceived plan according to the filing, which would have given me a lot more confidence. Instead, the filing showed that it was a rather rushed deal that began in February, with Microsoft starting the evaluation of the potential transaction in March. The events are quite telling. Supposedly, Nadella had no idea just four days before the signing of the agreement of what were the potential cost synergies. Even if he was talking about incremental synergies (i.e. those that were not considered before), was it really possible for Nadella to make a good judgment in under four days?
First of all, when dealing with potential M&A situations, there’s often very little time to act before arriving at a decision. What the author misses, is that the technology M&A space tends to move fast, and there’s very little time to act on a potential opportunity when a company is shopping itself around.
This isn’t investment management where you’re looking to buy portfolio companies as a part of a stock portfolio. This is Microsoft’s strategic gamble within the space, with acquisitions having a binary outcome of being a hit or total miss. The acquisition premium was in-line with historical M&A premiums within the tech space, so it’s kind of surprising we’re hearing this much backlash from the retail crowd.
I reached out to Daniel Broyles, a VC partner over at Good Funds, and his thought process on the Microsoft acquisition for LinkedIn was far more thought provoking. His thought process centered more on the potential for leveraging LinkedIn’s user behavior to create a Machine Learning (ML) alternative to Google’s in-house efforts for ML algorithms. I also added to that by mentioning that Microsoft’s end-game is to run some of its more proprietary big data algorithms to identify user behavior on its in-house social network to look for gaps in Microsoft’s current product portfolio. Microsoft recently mentioned that there was potential to integrate Lynda into Microsoft Word. But, I believe Microsoft’s biggest concern was the lack of visibility on user behavior. Since LinkedIn tends to be enterprise-centric, Microsoft has a better understanding of user needs, and can design next-generation Office 365 suites with better functionality/usability in mind. It’s really hard to design something without having a treasure trove of data, but now Microsoft is in a position to analyze billions of interactions similar to Facebook and Google.
Furthermore, the cost synergies aren’t likely to materialize in the form of headcount reductions on the SG&A line. The two businesses are so fundamentally different that the back-end administrative needs are quite different. Instead, Microsoft will likely leverage the combined advertising platforms of Bing-Yahoo and LinkedIn to create better ad-agency relationships with enough scale to provide better analytics, greater ad-inventory selection driving CPMs or CPAs even higher. The impact will center more on revenue.
The acquisition is reasonable and in hindsight will look as ingenious as Zuckerberg’s acquisition of Instagram, WhatsApp and Oculus. This is especially in light of Microsoft’s lack of compelling use cases for its ballooning cash pile that could have exceeded $100 billion had Microsoft not acquired LinkedIn. It’s also worth noting that RBC Capital Markets analyst, Ross MacMillan anticipates that the acquisition will drive 14% and 17% y/y growth in FY’17 and FY’18 respectively for the Productivity and Business Processes segment. This elevates the segment from historical mid-single digits growth. So, not only does Microsoft boost its near-term financial performance, it gives Microsoft greater visibility on emerging user preferences and provides incremental ad inventory to compete for agency spend in the next couple of years.
Not bad Satya Nadella. I’m surprised you pulled this acquisition off.
I still like Microsoft here. If you want the fortification of an AAA balance sheet, meaningful growth drivers and less of a consumer-oriented approach to technology then Microsoft is right for you.