- Microsoft's acquisition of Linkedln will help improve Linkedln's credit outlook and subsequently valuations.
- Microsoft will be forced to make Linkedln more cost efficient. Therefore, allowing Linkedln to be independent might not be effective.
- Also, would a partnership have made more sense than an acquisition?
Microsoft (NASDAQ:MSFT) and LinkedIn (NYSE:LNKD) on Monday announced that they have entered into a definitive agreement under which Microsoft will acquire LinkedIn for $196 per share in an all-cash transaction valued at $26.2 billion (the deal is inclusive of LinkedIn's net cash. LinkedIn will retain its distinct brand, culture and independence). The news caused Linkedln shares to surge by almost 50% to $192/share.
(Source: Google Finance)
How Microsoft is helping itself by helping Linkedln
The notion that Microsoft overpaid for Linkedln is becoming widely accepted. The company trades at ~45X forward P/E despite having negative Trailing Twelve Month ("TTM") profit margins (-5.27%), TTM operating margin (-5.32%), TTM Return on Assets (-1.68%) and TTM Return on Equity (-4.16%).
But Microsoft is helping itself by helping Linkedln. Let me elaborate.
From the aforementioned risks, it is clear that Microsoft might have overpaid but if they can manage to capture the synergies from integrating the two companies, it will be worth it. These synergies will come from improved valuations, good credit outlook, better cost efficiency and expanded margins.
- Microsoft's acquisition of Linkedln will improve Linkedln's credit rating. This will subsequently help improve Linkedln's total valuation and thus Microsoft's valuation.
The higher credit rating will come from the fact that Microsoft is a tripple A rated company and Linkedln is a junk-rated social network.
Standard and Poor ("S&P") already affirmed Microsoft's tripple-A rating despite the fact that Microsoft plans to finance the $26.2 billion Linkedln acquisition in cash with new debt.
S&P credit analyst David Tsui said in his note that he had some concerns about Microsoft's increasing debt, but overall:
"Our rating affirmation on Microsoft Corp. reflects our view that the company's acquisition of LinkedIn Corp. adds to its diversified product portfolio to include a high-growth professional social networking company, despite LinkedIn's relatively small revenue base, at about 4% of Microsoft's total revenues."
This implies that Microsoft will be able to finance the deal without diminishing its credit outlook. In addition, as an independent entity inside Microsoft, Linkedln's total credit outlook will drastically improve. This should help improve valuations for the professional, social networking site.
Therefore, Microsoft's backing will make Linkedln much more attractive. A perception that is likely to bolster investor confidence in Microsoft overtime.
- Microsoft's efforts to capture the acquisition synergies might help to reduce expense redundancy in Linkedln and make the company more efficient and thus more profitable.
Linkedln has always had a high cost structure. This high cost structure has contributed to the decline in Linkedln's stock price. For example, in the last five years, SG&A costs have grown by an average of 49% year-over-year. And if extrapolated, SG&A costs might continue to rise.
The 49% average y/y SG&A growth rate is problematic because Linkedln's total revenues were growing at a slower pace. Total revenues have grown at an average of 46% y/y in the last five years.
(Source: Authors analysis with data taken from Morningstar)
Therefore, the potential for margin expansion for Linkedln is another accretive opportunity that can come from this acquisition.
The risks: Was Linkedln an impulse decision? Could a partnership have made more sense than an acquisition?
I cannot help but wonder, was this an impulse acquisition that both parties are likely to regret down the line?
Microsoft might realize that the synergies are not worth the price and Linkedln needs better cost management. Meaning that before Linkedln becomes an independent entity within Microsoft, Microsoft will need to intervene to improve efficiency and reduce cost.
Aside from allowing Linkedln to operate as an independent entity within Microsoft, another selling point for the acquisition is the ability to scale the reach and scale of Linkedln. This will be done by leveraging Microsoft's ecosystem of over one billion customers by combining things like Linkedln's graph throughout Outlook, Calendar, Active Directory, Office, Windows, Skype, Dynamics, Cortana, Bing and more.
But one would wonder whether Microsoft could have achieved such synergies through a partnership and not a 50% premium on Linkedln. This could ensure that Microsoft achieves synergies without spending $26.2 billion. For example, Google partnered with Twitter to allow tweets to be discovered on Google search. This allowed Google to benefit from Twitter's popularity without spending any money.
The next question is whether or not Linkedln could have agreed to a partnership. The answer is likely yes. This is because Linkedln' s stock price was struggling. The stock was down more than 40% since last year this time. This stock price declining emanated from the fact that Linkedln's overall revenue growth was declining. For example, this past February, Linkedln's stock price fell by 43.6% (losing ~$11 billion of market value) to near a three-year low of $102.89/share after the company's revenue forecast fell far short of expectations. This caused a lot of downgrades because the company's high valuation could no longer be justified at that point.
Implying that management was under pressure to revive sales and investor sentiments in the stock. Meaning that the company was likely to partner with Microsoft just as it was likely to be bought. Implying that it is possible for Microsoft to have achieved synergies without spending $26.2 billion on Linkedln.
The fear I have is that Linkedln is allowed to preserve its culture by operating as an independent company within Microsoft. But to achieve the aforementioned cost synergies, the culture might need to be disrupted. Spending needs to be minimized and costs need to be better managed. Unless such action is taken, Linkedln's problems might destroy any potential synergies that Microsoft expects to realize from the acquisition.
Nonetheless, Linkedln will prove to be an optimal and natural entry point into the social networking business for Microsoft. It is an optimal and natural strategy because Microsoft's core businesses rely on gaining new enterprise clients. These are the same clients most likely to be on Linkedln than on Facebook or Twitter.
Linkedln is a necessary networking site. Unless something better comes along, it is still the dominant player in talent solutions. Looking forward, as long as people continue to look for jobs and continue to change jobs, Linkedln is a necessary tool. With Microsoft on board, the company can expand its dominance in the enterprise market. Become a great tool for finding top talent, connecting with relevant people to make great deals or sell software to companies.