04/28/2017

Microsoft Corporation & LinkedIn Corp. – Post Deal Value Expectations

Microsoft Corporation & LinkedIn Corp. - Post Deal Value Expectations

We published an article to our clients earlier today breaking down Microsoft’s acquisition of LinkedIn to better understand the performance expectations that would be priced-in to the combined company to justify current trading levels. This explanation put together by Derek Bergen, The Applied Finance Group, LTD. provides insight into the potential value of the combined firm and whether or not Microsoft overpaid for LinkedIn.

Earlier this week, Microsoft announced plans to acquire LinkedIn in a $26.2 billion cash deal at a 50% premium above LNKD’s market price at the time.  While it appears that there is an overwhelming consensus in the immediate reaction that Microsoft likely overpaid in this transaction, there is also a bullish perspective regarding the integration of LinkedIn’s network into both Office 365 and the CRM tool that Microsoft is developing as a relevant competitor to Salesforce.  While details on the specifics of the deal, as well as the potential value of the merged product offering between Office 365, Microsoft’s CRM platform, and LinkedIn, are emerging, we can use AFG’s Proforma Builder to attempt to evaluate the intrinsic value of the combined company through the performance expectations that justify current market value.

Example Articles:

Bear Perspective:

4 Reasons Microsoft Wasted $26.2 Billion To Buy LinkedIn, Peter Cohan, Forbes.com

Bull Perspective:

Satya Nadella explains in a sentence the real reason he bought LinkedIn … and Salesforce should be worried, Julie Bort, Business Insider.com

Management Perspective:

Microsoft’s and LinkedIn’s vision for the opportunity ahead, Microsoft & LinkedIn Management

First, we can evaluate Microsoft on a stand-alone basis, based on analyst forecasts available before the deal was announced.  This stand-alone model will not include any adjustments to finance the all-cash deal, but we will address deal specifics later in our merged MSFT/LNKD model.

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*AFG Proforma Builder, Value Expectations, 6/15/2016

This scenario is based on roughly -2% sales growth in 2016, followed by inflationary growth through 2020.  EBITDA Margins have been trending downward, and levels around 36.5% reconcile consensus EPS in 2016, and we will assume that margins would continue to mildly decline to 36% by 2020.

Using the Export button on the Proforma Builder toolbar, we can create a separate worksheet of historical and forecast financials as we prepare to develop a model based on the merged company.

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*AFG Proforma Builder, Export Data, 6/15/2016

The worksheet above provides an example of the exported data for MSFT.  While this set of exported notes contains 16 spreadsheets with various sets of fundamental data and AFG model calculations, we will only need to focus on the Balance Sheet, Income Statement, and Supplementary Data for our project.  For the time being, we can set this workbook aside, and begin to develop a similar set of financial statement data for LinkedIn.

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*AFG Proforma Builder, Value Expectations, 6/15/2016

Similar to MSFT, I’ve used consensus data for 2016 and 2017, then simply scaled down growth by 300 basis points per year through 2020, while giving LNKD benefit of the doubt that margins would continue to expand significantly over 2015 levels.  This model is still lagging consensus EPS in 2017 by nearly $0.40/share, but still reflects significant growth and margin expansion with an eye on trying to maintain a conservative approach towards forecast assumptions.

We can then use the Export button to create a set of raw LNKD financial statement data.

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*AFG Proforma Builder, Export Data, 6/15/2016

We now have two sets of financial statement data for MSFT and LNKD.  In a new excel workbook, we can create a set of custom Balance Sheet, Income Statement and Supplementary Data that combines the two sets of historical financials into one consolidated workbook.  Note that MSFT has a June fiscal year end, while LNKD has a December fiscal year end, so this consolidation set of financials will be slightly mismatched.  The only significant change to either of these firms reported data since the end of their most recent fiscal year end is related to the debt that Microsoft has begun to accumulate over the last two quarters, and we will address this when we consider the financing aspects of this deal.  Otherwise, there are not any other material changes that could be problematic when consolidating each of the financial statements.

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*AFG Research, Custom Consolidated Data, 6/15/2016

Notice in the example above that I simply added the various line items together.  This technique would apply to all line items on the Income Statement and Balance Sheet, as well as Normalized Rental Expense, Normalized R&D Expense, Depreciation Expense, Amortization Expense, Special Items, Common Dividends, and Preferred Dividends on the Supplemental Data worksheet.  We could also adjust the shares outstanding to attempt to reconcile the value of LinkedIn’s market cap as additional outstanding shares of Microsoft historically, which would be useful for advanced valuation adjustments by understanding model accuracy historically, but since this is an all-cash deal and advanced valuation themes are not a concern, we can skip more detailed work on the adjusted share count over time.

After opening a fresh copy of the default MSFT model in the Proforma Builder, we can use the Input Mode to insert our consolidated financial statement data.

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*AFG Proforma Builder, Input Mode, 6/15/2016

 

Note that if you plan on replicating this process to analyze other M&A deals, make sure you set the Use Overrides field to “Yes” in the upper left corner of the spreadsheet.  We can then copy/paste our consolidated financials into the Overrides section in columns V through AG, then press calculate to makes sure that these overrides are incorporated into the editable model interface.  We can now further incorporate the details of the acquisition to ensure that any deployment of cash, addition of debt, or dilution of shareholders are properly incorporated.

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Microsoft Announcement Notes, June 13, 2016 – Microsoft’s and LinkedIn’s vision for the opportunity ahead

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*EquityInsights.com, Financials, 6/15/2016

From the two screenshots above, we can see that the LNKD in purchase is an all-cash deal, being funded through a new debt offering.  MSFT has taken on roughly $13B in new debt over the prior two quarters, so until additional information becomes available, we will assume that this will be used to finance part of the deal in our model.  Note that in Q2, current debt fell by nearly $7B as MSFT converted soon to mature bonds into longer duration instruments, so it’s possible that we could be understating the overall debt level by several billion dollars if our assumption is not accurate.

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*AFG Proforma Builder, Balance Sheet, 6/15/2016

Based on the assumptions noted above, we will assume an additional 13-14 billion in new debt to finance the LNKD purchase.  A forecasted long-term debt level of $56B in total debt should satisfy this, but the total amount could be closer to $60B or $65B depending on how you interpret management’s implication of “Purchase price to be financed primarily with new debt” from their announcement and whether that includes recently issued debt or not.  In addition to this, we can increase Net Intangibles $19B to a total level of $43B in 2016, based on the $26B purchase price less $7B in total assets for LinkedIn.

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*AFG Proforma Builder, Value Expectations, 6/15/2016

Ignoring any assumed cost savings or new markets created by the combined company, MSFT appears to have an intrinsic value around $43 based on consensus estimates for both companies on a stand-alone basis driving our forecasts.

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*AFG Proforma Builder, Value Expectations, 6/15/2016

We can further model a scenario where we take management at their word on anticipated synergies, which they claim to be 150M by 2018, or a roughly 16 basis point improvement in EBITDA Margins.  In addition to this, the LNKD earnings per share impact for MSFT should be negligible, since LNKD consensus EPS estimates of $0.13 in 2016 and $0.79 and 2017 convert to $0.002/share in 2016 and $0.013/share in 2017 when adjusted for MSFT’s share count before adjusting for the offsetting impact of additional interest expense created from additional financing.

In order to appear fairly valued based on yesterday’s closing price, MSFT would need to deliver sales growth of 5%, while margins increase by 200 basis points over the next five years, which reflect roughly the same level of EBITDA Margin realized as recently as 2013.  Over the last five years, however, margins have declined from 43.0% down to 35.6% last year, so it appears that management has made a significant bet that the impact of LinkedIn’s product offerings can serve as a catalyst for additional sales growth and margin improvements across Office 365 and CRM customer bases. (The scope of this article is based on determining if MSFT is attractive at its current price based on implied expectations.  To further judge the management team based on the success of this acquisition, we could use the $51.48 closing price for MSFT on June 10 as our “fair value” for Microsoft.  To deliver intrinsic value in excess of the firm’s share price before the deal was announced, MSFT would need to see margins further improve to 38.5% by 2020.)

Note that our Proforma forecasts above reflect performance that MSFT would need to deliver to be fairly-valued, so if your post deal expectations for MSFT are in excess of this, you could use this to help formulate an attractive investment thesis for Microsoft.  Alternatively, if these expectations seem a little aggressive, this analysis could also further support an unattractive thesis.  It’s important to note that Moody’s is reviewing the Issuer Rating for Microsoft, as well as its Senior Unsecured Rating in light of the announcement to take on $26B in new debt, which could further impact the cost of capital for the firm through increased interest expense.

Overall, forward-looking forecasts of the impact of this transaction on Microsoft’s sales growth and margins are murky at best, but hopefully this article provides meaningful insight in the process that AFG can apply to determine a reasonable set of forecasts that should be placed on MSFT to justify their current stock price.  While new details emerge and yield clarity in performance expectations, we can continue to refine our forecasts to estimate a more precise intrinsic value for MSFT, but in the interim, we can use implied expectations to determine if performance implied is likely to be achievable.  In this case, it doesn’t appear to require too drastic of a margin rebound or unrealistic sales growth assumptions to justify Microsoft’s market value, but it will be interesting to see if management can now deliver or exceed this performance over the next five years.

 

About Derek Bergen, CFA 2 Articles

Partner at The Applied Finance Group
Focus areas: Equity Analysis, Portfolio Consulting, Quantitative Research.
Joined AFG in 2005

About Derek Bergen, CFA 2 Articles

Partner at The Applied Finance Group
Focus areas: Equity Analysis, Portfolio Consulting, Quantitative Research.
Joined AFG in 2005