Description

MSFT currently trades at an EV/FCF of only 12x, based on my estimate of $20B in FY ’08 (6/08) FCF.  The market’s negativity on the Yahoo! deal, combined with the market’s lack of recognition for Microsoft’s stellar operating momentum is providing a fat-pitch opportunity.

On January 24, 2008, Microsoft delivered Q2 ’08 results that beat management’s high-end forecast for both revenue and operating income.  The results were uniformly outstanding, the outlook was strong, and yet the stock failed to rally – hanging around $32.60.  Then, on February 1, 2008, Microsoft announced a hostile offer to acquire Yahoo! for $31 per share, representing a $44.6 billion offer, structured as half cash, half stock.  From the time of the acquisition announcement until now, Microsoft has lost $39.0B in market cap.  This is incredible considering that the EV on the Yahoo! purchase would be only $32.8B (net of $1.6B in cash and $10.2B in minority investment stakes, adjusted both for estimated taxes and a 10% liquidity discount).  At the current level under $28.50, MSFT is priced at an EV to estimated FY ’08 FCF (ex interest income) of a mere 12.0x.    

I’ll briefly summarize Microsoft’s financials and recent business performance.  Microsoft is on-track to generate FY ’08 revenue around $60B, up 17-18% YOY.  Total bookings growth in the latest quarter was up 20% YOY.  (Microsoft has said in the past that bookings growth is the single-best metric for isolating the relative strength of any one quarter.)  The underlying PC market remains robust, despite a slowing US economy.  PC unit demand in the Dec ’07 quarter was up 14-16% YOY, about 300bp higher than Microsoft’s previous forecast for the quarter.  From a geographic perspective, more than 60% of revenue is now derived from users in regions outside of the US – comprised of 48% in mature international markets and 14% in emerging international markets.  Revenue in those regions drove growth with non-US mature markets up over 20% for the first half of the year and emerging markets up nearly 30%.  This geographic diversity provides Microsoft with excellent resiliency amidst a slowing US economy.  That said, US growth in Q2 ’08 wasn’t shabby either, up 15% YOY. 

In terms of profitability, Microsoft’s FY ’08 operating income is expected to be in the range of $24.2 billion to $24.4 billion, up 31-32% YOY.  Guidance has been increasing each of the past several quarters, with current guidance now 9.2pp above the original Apr ‘07 mid-point guidance and 3.5pp above the guidance from Oct ‘07.  Deferred revenue is expected to finish FY ’08 up 14-16% YOY, 6pp or about $750m above Microsoft’s Oct ’07 guidance.  Based on this guidance for operating income and deferred revenue, I can infer a rough estimate of full-year structural FCF – if I assume 20% capex growth (on top of FY ‘07’s 43% capex growth), I come to a full-year FY ’08 SFCF estimate, ex interest income, of $20B, up 22% YOY. 

Valuation:

At the current price of $28.50, Microsoft carries a market cap of $270.8B and EV of $240.3B.  This is an EV/SFCF multiple of only 12.8x on a TTM basis and 12.0x on a forward FY ’08 estimated basis.  I believe this is the lowest multiple to FCF that Microsoft has ever traded at.

In terms of product cycle outlook, Microsoft continues to benefit from Vista’s momentum, with that product just now entering its second year of general availability.  Office 2007 is also just in its second year.  Lastly, in February, Microsoft launches several updated products in its Server & Tools division:  Windows Server 2008, SQL Server 2008, and Visual Studio 2008. 

Here’s how I translate this outlook into DCF assumptions:  Overall, I’m expecting both revenue and operating income growth in FY ’09 to be in the low double digits.  Looking out to FY ’10 and beyond, I’m operating on the general assumption that as long as MSFT maintains its core moat, it should be able to find opportunities for upper single-digit growth from some combination of new products, pricing power, growth in online advertising, and probably some efficiency gains if it were really motivated.  Then, beyond Year 10 in the model, I’ve pulled growth down to the low-to-mid single digit range to account for what inevitably becomes the law of large numbers.  These assumptions translate into the following range of fair value:

In ascribing fair value to Microsoft of $40-45, we’re talking about an EV/FCF range of roughly 17-20x, which seems quite reasonable to me for one of the world’s finest businesses that’s still growing steadily.

Yahoo! Acquisition Offer

Let’s now discuss the Yahoo! deal…

On February 1, 2008, Microsoft announced that it has made a proposal to the Yahoo! Inc. Board of Directors to acquire all the outstanding shares of Yahoo! common stock for per-share consideration of $31 based on Microsoft’s closing share price on January 31, 2008, payable in the form of $31 in cash or 0.9509 of a share of Microsoft common stock, representing a total equity value of approximately $44.6 billion.  Microsoft’s proposal would allow the Yahoo! shareholders to elect to receive cash or a fixed number of shares of Microsoft common stock, with the total consideration payable to Yahoo! shareholders consisting of one-half cash and one-half Microsoft common stock.  The offer represents a 62% premium above the $19.18 closing price of Yahoo! common stock on Jan. 31, 2008. 

In the letter to Yahoo!’s Board, Microsoft revealed for the first time publicly that it has in fact been in discussions about such a combination for more than a year.  This is a deal which Steve Ballmer personally has had the opportunity to contemplate for an extended period, and his verdict is that the deal makes more sense than ever. 

Let’s step back and look at what assets Yahoo! brings to Microsoft.  Yahoo! is the number one destination on the web with 2.7 billion page views per day.  Whereas Google is the #1 player in search advertising, Yahoo! is #1 in display advertising (banners, buttons, etc.).  While it will be tough to erode Google’s leadership in search, a combined Microsoft-Yahoo! would have better ability to devote greater R&D resources toward this end.  From a financial perspective, Yahoo! in 2007 generated FCF of $1.35B on revenue of $7.0B, representing a 19.3% FCF margin.  Notably, this excludes the earnings power of various minority investment stakes such as Yahoo!’s 34% interest in Yahoo! Japan and 44% interest in Alibaba of China.  These stakes, which are publicly traded, have a market value of nearly $12 billion.  When adjusted for taxes and an estimated 10% liquidity discount, these minority stakes would still be worth roughly $10.2B.  In addition, Yahoo! has net cash of $1.6B.  All told, the true EV being paid by Microsoft for Yahoo!’s operating assets is only $32.8B.  And with those operating assets generating cash north of $1.3B, the true EV/FCF multiple being paid by Microsoft is only 25x.

Microsoft’s strategic rationale for this acquisition centers upon the opportunity to eliminate redundant costs and reap scale economies from creating a unified advertising platform with Yahoo!.  Regarding cost eliminations, Microsoft will be able to eliminate duplicate engineering efforts associated with maintaining two separate ad platforms and search indexes, while also eliminating duplicate capex related to the infrastructure of servers and data centers that support search.  Regarding the scale benefits of a larger, unified ad platform, the rationale is that a larger network presents a superior value proposition to both advertisers, web publishers, and website viewers – i.e., a network effect whereby a larger quantity of ad inventory creates greater appeal to advertisers (motivated to reach a larger audience), which in turn attracts more web publishers (motivated to maximize its cut of ad revenue on a larger audience), from which the greater availability of published content attracts more web users, which then circles back to attract more advertisers, and thus the beneficial cycle circles on and on.

In terms of quantifying these synergies, Microsoft has lobbed out the figure of $1 billion in expected savings.  I think this is a throwaway number that will be very easily achieved.  The fact is that Microsoft’s present Online Services Business has incurred an operating loss of nearly $1 billion over the TTM, and part of those losses is attributed to inadequate scale.  Just the scale factor alone should help Microsoft reverse its current OSB losses and thereby reap immediate synergy of nearly $1 billion.  All other synergies beyond that will be gravy. 

Much has been made in the media over the potential for culture clash between Microsoft and Yahoo!, but I think this issue is overdone.  I think Yahoo!’s appeal with consumers is evident and intact, and no amount of culture clash is going to change the fact that Yahoo! is the most visited site on the web. 

As for EPS dilution, Microsoft has said it expects the deal would be accretive to EPS by the second full fiscal year following the deal’s closure, which implies by FY ’11.  I  think this is very conservative – I wouldn’t be surprised if Microsoft can achieve many of the deal’s synergies within 12-18 months after closing, i.e. FY ‘10.  Not that EPS accretion/dilution is of any real economic significance, but I’m merely noting it here for the record.  Clearly, what really matters is the opportunity for Microsoft to turn a current money-losing division into a big and growing money maker – and that’s of tremendous economic significance.  I see no reason why the combined Microsoft-Yahoo! shouldn’t turn Microsoft’s current OSB operating loss of $1B into an operating profit of more than $2B within 3-5 years.

While this acquisition announcement thus far has caused a quick 13% hit to Microsoft’s market value, I think in the long term that the market will come to appreciate this acquisition as an act of savvy capital allocation at a time when Yahoo! was vulnerable to a low bid.  The main risk I see right now is that in Microsoft’s desire to get this deal done that it might sweeten the offer a bit, and thereby cause some further downward pressure on MSFT shares.  That said, as of yesterday’s close, YHOO at $28.57 is trading at a 1.7% discount to the implied deal price, which isn’t overly suggestive of the market expecting a much higher offer for YHOO.

Conclusion

Microsoft remains the undisputed PC tollgate and one of the most formidable financial engines the world has ever known, en route to $20 billion in FY ’08 FCF.  At the current price of $28.50, you can buy this technology leader at a mere 12x FCF multiple.  At a time when US economic growth is slowing, Microsoft benefits from generating more than 60% of its business from outside the US.  Also, in the midst of strained financial markets, Microsoft stands out for its world-class balance sheet of $30+ billion in cash and trading liquidity – both comforts to risk-averse investors.  Finally, Microsoft is to be commended for prudently investing in future growth opportunities such as online advertising, where the acquisition of Yahoo! provides an ideal opportunity to gain the leadership position in display advertising, along with the necessary scale to turn a current $1B operating loss into a potential multi-billion operating profit within 3-5 years.

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