The announcement was made that Microsoft Corporation reached an agreement to purchase LinkedIn for $26 billion, a 49.5% premium over the prevailing market price. LinkedIn was ripe for acquisition. While LinkedIn was hardly struggling, the growth story was sagging, and investors were starting to become restless. Starting on February 1, 2016, LinkedIn shares’ price fell from $205.76 to $108.38 on February 5, 2016, and had recovered a bit since, reaching $131.08 just before the acquisition.
The markets are shocked. This splash seemed to come out of nowhere. Has Microsoft’s CEO, Satya Nadella, credited with making Microsoft exciting again and a meaningful player in the business hardware market for the first time in its history, finally blundered?
Let’s dissect the deal. Any time we look at the acquisition of a publicly traded company, we need consider the control premium. Publicly-held shares are generally understood to traded on a minority basis and thus the market places a premium simply for the prerogative of control. At present, the market price for a control premium is around 30%. Simply adding 30% to the share price of $131.08 gets us to $170.40/share. That’s much closer to the $192.21/share acquisition price (a price seen only 4 months ago), but a material gap persists. This isn’t just a control-driven transaction.
Another piece is the financing. Microsoft plans to borrow to pay for the acquisition, even though it technically can pay cash for this deal four times over. However, much of that cash is stuck abroad and Microsoft would rather avoid the repatriation tax. More to the point, however, is simply a cost of capital issue. Microsoft’s debt rating is AAA, which, according to the Federal Reserve, is an interest rate of 3.54% assuming a 20-year maturity. Since interest is tax-deductible, we’ll apply a tax rate of 35%, for an after-tax cost of financing of 2.3%. LinkedIn’s cost of equity can be estimated using the Capital Asset Pricing Model, where the cost of equity = risk-free rate + beta*(equity risk premium).
Risk-free rate = 2.12% (Federal Reserve)
Beta = 1.38 (Yahoo Finance)
Equity Risk Premium = 6.03% (Duff & Phelps 2016 Valuation Handbook, Guide to Cost of Capital, supply-side equity risk premium)
Accordingly, the cost of equity financing for LinkedIn is 2.12% + 1.38*(6.03%) = 10.44%.
This means that Microsoft had a lower required rate of return on LinkedIn’s shares than LinkedIn’s own shareholders by a factor of over 4 (10.44% vs. 2.3%). To Microsoft, these shares must have seemed cheap. In other words, the acquisition doesn’t have to do all that well to justify the acquisition price. Financially, this acquisition is a slam-dunk for Microsoft.
What about the other side of the coin? Should LinkedIn have held out for more? Perhaps, but I think there were a couple of factors at work here. One is the fact that Microsoft a few years ago made a pretty strong bid for a company called Yahoo! in 2008, which was turned down and Yahoo’s market capitalization is down 25% since then. I’ll bet LinkedIn’s board didn’t want to be Yahoo II. Yahoo also plays another dynamic in that it is aggressively marketing itself and Microsoft is rumored to have interest in another go, meaning that LinkedIn had to consider its leverage limited if Yahoo! were considered a relatively viable substitute. It’s reasonable to speculate that LinkedIn’s board saw the opportunity to recover their February 2016 share price overnight, look like heroes to its shareholders, and call it a day. As they say down here in the South, pigs get fat, but hogs get slaughtered.
It’s also hard to see who the other buyers would be. Would Verizon try to match Microsoft dollar for dollar in a bidding war? Doubtful. Apple seems content to build around its own, captive community, (which appears content to support the Apple mother ship regardless of how it clearly disdains its own customers as its consumer-grade computer hardware becomes ever more obsolete). Facebook is the 800 pound social networking gorilla and probably prefers to try to compete with LinkedIn than buy it – and their history suggests they wouldn’t have paid cash for the deal anyway. Twitter isn’t buying LinkedIn, and Alphabet seems to have been sufficiently bruised by its tentative foray into social networking (remember Google Circles? The Jar Jar Binks of the social networking world?) that it’s not inclined to make a huge, financial bet in the space again. A merger of equals between LinkedIn and Yahoo! would have been interesting, but hard to bet on a successful outcome.
The curious part about this deal is that is fails to address a key strategic gap that is common to both Microsoft and LinkedIn – that of mobile markets. Facebook, Google, Twitter and Apple are dominating the mobile market. Microsoft just never caught up, but you can’t fault them for not trying, and LinkedIn’s mobile interface has historically been, incredibly, just awful – like Battlestar Galactica 1980 awful. Microsoft is getting a bunch of business users (100 million monthly users), but it’s unclear how they will be integrated (and somehow linked) to the Microsoft platform. But, LinkedIn is probably the best available business social network that was available for sale, and given the low cost of financing, it’s worth a shot.