Quick Thoughts: Shopping Lists Part 3, Microsoft’s Turn

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–          Microsoft has $63 billion in cash with which to strengthen its case as a viable third platform vs. iOS and Android.  It starts with strength in enterprise but real weakness with consumers.

–          Ecosystem backlash to a Nokia deal may be overstated, while hardware expertise, maps, IPR and a sub $10B valuation are compelling.

–          LinkedIn adds social networking to Microsoft’s cloud apps and bridges to Microsoft’s recent Yammer acquisition.  OpenTable is a restaurant software vertical with an interesting cloud component.

–          Activision is already on the block.  Buying it and Netflix would strengthen Xbox’s lead over Apple in TV.  SourceFire expands Microsoft’s security tools to the network, closing a hole in enterprise offerings.

On the new era platform stage, Apple and Google have hogged the spotlight, but Microsoft has an important role to play in Act II.  With the coordinated fall launches of Windows 8, Windows Phone 8, Office 2013, Outlook.com, and Surface, the folks in Redmond are beginning by addressing business needs that are not well served by either of its more consumer oriented rivals.  Enterprise adoption of Windows 8 may be slow, but the synergies out to the portable world of tablets and smartphones will be real and valuable.  Of course, this is not to deny that Microsoft has some substantial holes to fill as well, if it hopes to stand up to the iOS and Android juggernauts.  Luckily, Microsoft has cash, and it has been known to use it.  Mister Softy was one of the most active acquirers in the market prior to the economic crisis, buying 50 companies between 2006 and 2008, including $6.2B aQuantive in 2007 which was recently written off. The pace of acquisition then slowed to 6 companies in 2009, 2 in 2010, 3 in 2011 including a whopping $8.5B for Skype, and 2 in 2012 year to date including Yammer for $1.2B. With $63B cash in hand and tempered values in the market post-Facebook, Microsoft can be expected to go shopping.

A quick inventory of Microsoft’s position: Tablets are laying waste to the home PC market, and with it, Microsoft’s biggest play for consumer.  Bing, MSN, and Skype are part of an online services business that has lost over $2B in each of the last three fiscal years.  Mobile Windows was a massive disappointment for over a decade, with the recent extreme makeover to the Metro interfaced Windows Phone 7 a promising but potentially insufficient play to erase the mistakes of the past.  Xbox has been a slow but successful slog for Microsoft, finally turning profitable in 2008 after seven years of losses, taking clear leadership in the global gaming console market and using its 26% penetration into US households to become the leading portal for TV access to online video.  On the enterprise side, Microsoft faces the deterioration of its dominant device OS and packaged software franchises, but unlike most other IT stalwarts, it has aggressively positioned itself for the move to the cloud.  While Azure, Windows 8, Office 365, and other cloud plays are an excellent start, Microsoft can be expected to press forward in SaaS applications and enterprise oriented mobile devices.

So what will they buy next? Here are our picks:

Nokia:  Since announcing the Microsoft partnership, Nokia’s market cap has declined by $25B to just below $10B and the company is laying off about 10% of its staff. While the Windows Phone based Lumia smartphone line has been generally well received by critics, demand has built slowly.  Nokia shipped just 4M Lumia phones in Q2 versus Apple’s 26M+, a disappointing quarter for the iPhone with demand hanging on the upcoming 5G launch. Meanwhile, the bulk of Nokia’s historic sales have been of feature phones, a product category that is being eviscerated by the portable platform revolution.  The resulting drain on Nokia financials is the impetus behind the company’s huge losses and the resulting implosion of its share price.

Of course, one man’s folly is another man’s gold.  Behind the losses, Nokia retains one of the world’s pre-eminent portfolios of mobile patents, a proud and talented engineering force, leadership in navigation and location-based technology, and a far reaching global distribution network that could be had on the cheap.  A deal for Nokia would take Microsoft’s leading hardware partner off of death watch and add considerable synergy to Microsoft’s own hardware efforts.  While such a deal would draw consternation from Microsoft’s current ecosystem of hardware partners, we are already several miles down that road with the announcement of the Surface and the already cozy relationship with Nokia.  Microsoft will join Nokia on stage when the new Lumia phones are announced on September 5th.  Why not just make the whole thing legal?

LinkedIn:  The Yammer deal takes Microsoft into enterprise social networking, a concept pioneered by Salesforce.com’s Chatter.  Given Microsoft’s broad reach advantage over every other enterprise software competitor and its domination of the closely aligned enterprise email business, the synergy with Yammer would seem assured.  LinkedIn, with its nearly 200M users and its tight focus on professional networking, could be a huge bridge between Yammer’s private enterprise functionality and the broader business social networking community.  Moreover, unlike many social networking players, LinkedIn has demonstrated clear vehicles for monetization – e.g. premium subscriptions for job seekers, paid job postings and advertising – and has shown profitable growth since 2006.  With a market cap of $10.9B, a deal premium would put the price tag at least twice any of Microsoft’s previous purchases, but then again, it could be worth it.

OpenTable:  With 44% penetration of some 35,000 reservation taking restaurants in the US, OpenTable has established both critical mass and barriers to competition. OpenTable sells an entire reservation system to its restaurant clients, including on-site hardware and software installation. Pricing consists of a flat monthly fee for equipment and performance based fees for diner referrals, and only restaurants are charged while diners use the service for free. OpenTable’s reservations business is not easily replicated given the fragmented nature of the restaurant industry. It took years of knocking on doors and cold calling to achieve its installed base of 25,000 restaurants in the US. Urbanspoon’s RezBook entered the reservations market last year and despite smaller fees, has only a fraction of the restaurants served by OpenTable. While OpenTable shares have faced pressures stemming from Google’s acquisition of Zagat and fears over new entrants, it still has some room for growth, particularly from international expansion.  OpenTable’s software driven business model is an excellent fit with Microsoft, which has global small business sales channels to exploit in pushing expansion into new markets.  The consumer service aspect of the business could become an important element of the Windows Phone/Windows RT integrated application suite and an app foothold into both the iOS and Android ecosystems.  At a market cap of just over $1B, a deal for OpenTable would hardly tax Microsoft.

Activision Blizzard:  Vivendi has announced that it is seeking a buyout of its $8.1B stake in Activision, publisher of wildly popular video game franchises like “World of Warcraft” and “Call of Duty”.  As Microsoft beefs up the networked gaming offerings on its Xbox live network and ties it to its Windows Phone 8 and Windows RT consumer offerings, Activision’s leadership in the gaming market could create substantial synergies unavailable as an independent publisher.  Moreover, the popular characters associated with Activision games could be leveraged to original video programming as well, well matched to Microsoft’s own blockbuster franchise, Halo.  Given that Vivendi has floated the idea of selling its stake directly into the market, which would require a haircut from its current valuation, it would seem that Activision could be bought with relatively little premium.  It is rumored that the two companies discussed a deal at Allen & Company’s recent Sun Valley conclave.  While the alleged talks may have been unsuccessful, it does not preclude reaching agreement at a later juncture.

Netflix:  Netflix is at a risky juncture in its history, as prices for the studio movie libraries that have been its bread and butter look poised to rise, and pressure from on-line and traditional cable competition seems apparent.  Nonetheless, Netflix is seeing huge increases in usage by its subscribers and is countering competition by funding a range of promising original programs.  The strategy is entirely reminiscent of HBO’s leap to original programming in the salad days of cable, and has more than a chance of success.  Xbox is already the number one vehicle for Netflix, which could be the core of a more coordinated play to position the gaming console as an overarching online gateway for the television, one that could be integrated tightly with Windows phones and tablets.  Microsoft could pick up Netflix for a modest premium above the $3.5B cap and deliver an advanced TV solution to the 40 million Xbox households, beating the much rumored AppleTV to the punch.

SourceFire: Microsoft already has its own suite of security products called Microsoft Security essentials, but it only covers the OS from Malware threats. As new devices have emerged along with increased cloud delivery, so have security threats. SourceFire is an innovative security player largely focused on network security. Synergies between SourceFire and Microsoft are obvious boosting an enterprise offering. Moreover, of all IT spending categories, security is an area not likely to be cut. SourceFire managed to increase US federal government revenue by 7% between 2010 and 2011 along with double digit growth in other categories. With a market cap of $1.5B, SourceFire would not be a stretch for Microsoft.

After the embarrassing write down of aQuantative and the skeptical view of the market toward Skype, Microsoft may be a bit gun shy to take on deals the size of the companies in my list.  The pace of acquisitions have slowed in the past few years and the company has sought more creative ways of exploring new markets via partnerships and equity stakes. Still, $63B in cash idling is not delivering shareholder value. Microsoft still has a way to go to become a full fledged platform in the mobile paradigm and the best way for it to become a contender against tough competition may be to open its wallet.

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