Consider this: Ebay (EBAY) is valued at $27 billion and earns $2 billion in annual profits. Ross Stores (ROST) is valued at $21 billion and earns over $1 billion in annual profits. Ebay has grown earnings by 14.5% per year for the past decade, and Ross Stores has grown earnings by 19.5% per year for the past decade.
And now consider this: Linkedin (LNKD), which is currently losing money and hasn’t earned a profit since 2013 when it posted a $26 million earnings figure, is getting bought out by Microsoft at a price of $196 per share for a $26.2 billion valuation.
That is crazy–I have no idea how you can justify this as being a better move than just launching a massive $26 billion buyback plan to retire 7% of Microsoft stock. The highest earnings estimate that I have seen from analysts covering LinkedIn is a call from Deutsche Bank for profits of $400 million by 2021.
If that prediction comes true, then Microsoft just paid over 65x earnings for what a multi-billion dollar company stands to make five years from now. LinkedIn is a real business–it brings in $476 million in through its advertising and talent search divisions. But it must spend $600 million to advertise its own site, pay its employees, keep the site up and running, and pay the rent and run the office.
And it already has 105 million monthly users with some signs showing that growth may even recede if online professional networks deflect to the “Facebook Professional” market launch or fall out of fashion as a business cultural norm. Assuming only modest growth in the 105 million user base, the question becomes: how do you double or triple the revenue generated by LinkedIn above its current rates within the next 5 years? And that’s just the threshold requirement to get to the 2021 figure that would be 65x earnings.
From what I can tell, LinkedIn shareholders just got away with one. The Microsoft acquisition was a huge blessing as a $26 billion valuation is very kind to a business that is losing over a hundred million dollars per year currently and has never even hit $30 million in profits in its history.
A lot of times, people engage in the defer to authority logical fallacy by saying, “Okay, well, Microsoft executives must know something or have some plan that the lay investor cannot comprehend.” But those types of arguments are just attempts to neuter your common sense.
Back in May 2007, Microsoft aQuantive for $6.3 billion which has so far required over $4 billion in write-downs and shows no promise of becoming an ad broker that can rival Google. Three years ago, Microsoft paid almost $10 billion to purchase Nokia and that may actually prove to be a full $10 billion loss within the next few years.
Microsoft seems to find itself in the same situation that Coca-Cola did in the 1980s. Back then, Coke was buying Columbia pictures and shrimp farms because it was trying to diversify and was generating torrents of cash in excess of what it could reinvest back into the core business. The wealth destruction at the early 1980s Coca-Cola was so extreme that Warren Buffett overshot things in the other way when he was a member of the Coca-Cola Board at the time it was contemplating buying Quaker Oats. He remembered the experience from the 1980s and was against the transaction because he didn’t want to buy an asset that decreased the earnings quality of the firm. Buffett’s caution was a great boon to shareholders of PepsiCo which acquired Quaker Oats in Coca-Cola’s stead, but it was at least understandable from the viewpoint of not wanting to repeat mistakes.
At Microsoft, there are torrents of cash coming in right now to the tune of $21 billion per year. Microsoft Office and the Windows software don’t require more than $1 billion in cumulative reinvestment, and Microsoft is already shipping off nearly $11 billion to shareholders as dividends. That leaves a lot of play money leftover (Microsoft’s cash hoard sits at $105 billion, though it’s more like $65 billion once you adjust for the repatriation taxes that would be necessary to bring that money back to Redmond).
Microsoft shareholders will likely be fine over the long term, as the core economic engine is so strong with its 23% profit margins and 7% annual product demand growth that it can withstand a lot of abuse and still do all right. But from a wealth maximization point of view, Microsoft shareholders would almost certainly be far better from an announcement of a massive buyback that increased their ownership interest in computer and Office sales.
Meanwhile, LinkedIn shareholders get a little bit of dotcom era nostalgia that will nicely paid their bank accounts. I think it’s hard to argue that LinkedIn’s maximum value is anywhere north of $5 billion. And now, the shareholders get a payout that is almost 5x greater than they deserve. The only catch? The kind of person who owned shares of LinkedIn is the same kind of person that won’t hesitate to take the $196 cash payout and then reinvest it into other social media companies trading at prices that have no relationship to earnings. This never works out over the long term unless (1) you get bought out again or (2) are Amazon from 1999 through 2016.