Image source: LinkedIn
It’s almost hard to believe that Microsoft (MSFT) CEO Satya Nadella would throw ~$26.2 billion of cash in the form of shareholder capital that could potentially go toward one of the best future dividend growth streaks in history at a large, Internet-based acquisition such as LinkedIn (LNKD), but it happened June 13. Unbelievable. We think most of the news outlets had to do a double-take before reporting the news (we did, too), and we’re not surprised that Microsoft’s shares are selling off on the announcement. Some are painting the deal optimistically, but we’re bummed out. We’re removing half of our position in Microsoft from the Dividend Growth Newsletter portfolio on the news at ~$50.18 per share for one of the biggest gains in the newsletter portfolio yet.
We probably should have known something big was brewing. Microsoft’s latest quarterly report, released April 22, left a lot to be desired, but we looked past many of the negatives in light of the company’s fantastic free cash flow conversion rate, and that it has one of the strongest balance sheets in the world gave us comfort that its dividend would grow for many, many years to come. Management seemed a bit distracted to have put up a report where earnings-per-share fell short of consensus in light of the flexibility brought about by a hefty share repurchase program. Something wasn’t right. Though Microsoft remains very, very healthy from a financial standpoint, we simply can’t justify Microsoft’s gamble with unproven LinkedIn, and the cash (in the form of new debt) going out the door is not resonating with income investors, us included. We’re not sure what happened in the boardroom at Microsoft, but clearly, the software giant is stretching for growth.
Synergies of the transaction may be limited. LinkedIn will remain independent, Jeff Weiner will remain the CEO of LinkedIn, and its brand will remain untouched. What in the world is Microsoft thinking? Couldn’t they have done a strategic partnership and saved ~$26.2 billion in shareholder capital? Even on a fundamental basis, we’re concerned. Our corporate interaction with LinkedIn hasn’t been helpful at all (where LinkedIn has refunded our ad money), and the website, in the opinion of many, has turned into an extension of the social interactions that can be found on Facebook (FB) – it’s no longer professional, but more social. LinkedIn users are confused – content is not unique, from what we can tell, and professional networks have grown so large that job-seeking may not be as clandestine as desired for many up-and-comers looking to move up the ladder. In 10 years, Facebook may be eating LinkedIn’s lunch. #RIPLinkedIn
CEO Satya Nadella believes that “together (MSFT-LNKD) can accelerate the growth of LinkedIn, as well as Microsoft 365 and Dynamics as we seek to empower every person and organization on the planet.” This may be true, but why use up a considerable amount of shareholder capital to do so? What a nightmare! LinkedIn is adding members and growing mobile usage, but we’re just not seeing a tremendous strategic fit, especially if LinkedIn itself will remain independent with little to no change at the top. It seems like Microsoft made the deal for the sake of making a deal, and LinkedIn, after one of its worst quarters arguably since going public, was only happy to oblige. LinkedIn shares are rallying considerably on the news, and we expect to raise our fair value estimate to the takeout price.
Microsoft will finance the transaction primarily through the issuance of new debt as it seeks to complete its $40 billion buyback program by the end of 2016, but income investors have been left in the cold with this transaction; it raises a big question about the board’s long-term commitment to the pace of dividend growth, even if future increases are assured. We want big increases to Microsoft’s dividend, not marginal ones. The numbers are terrible: LinkedIn’s near-$3 billion revenue stream in 2015 is but a fraction of Microsoft’s $90+ billion mark, and the professional networking entity’s negligible net income is sad: -$166.1 million (negative, 2015), -$15.3 million (negative, 2014), $26.8 million (2013), $21.6 million (2012), and $11.9 million (2011). By comparison, Microsoft generated, on average, $19 billion in net income during the past three years. Free cash flow at LinkedIn averaged ~$160 million during the past three years (2013-2015), while this mark has been nearly $25 billion on average at Microsoft during its past three fiscal years (2013-2015).
Microsoft is paying for potential and maybe long-term relevance, but we doubt the software giant will make good on this deal, if only through the lens of tangible financial statement analysis. It’s just too much money, too late into this phase of the economic cycle, for too little in profits and free cash flow. My goodness — $26+ billion at Microsoft effectively out the door! Start the clock for a coming impairment charge in coming years, even if this deal looks a lot different than the Nokia (NOK) fiasco of year’s past. Our valuation of Microsoft is full anyway, and it’s time for us to cash in, in part, on this tremendous winner over the past four years. We expect a modest downward revision to our fair value estimate of Microsoft on the news.