It's Official: Ballmer has lost it

I should probably add "completely" since there were signs of increasingly erratic behavior along the way. Starting early, for example, we saw extreme denial as he argued that the company would prevail against the DOJ and be found innocent. That was quickly followed by manic confidence in "emerging bets" which, 5+ years later (actually decades in some cases), are looking more like a disastrous binge in Vegas after failing to take his lithium versus anything remotely approaching a business investment. Then there were the delusional "bet on it" promises that Vista would be "great" and that MSFT would quickly catch and surpass GOOG [Apple, CRM, insert xyz other company kicking MSFT's butt then and still currently]. Thrown into the mix, were the occasional Tourette-like stock-tanking remarks - as in "Surprise! We're going to spend $2-3B more than we let on previously". However, as bad as that is - and it's pretty pathetic - it pales by comparison to news Friday that MSFT is set to acquire aQuantive for the astronomical price of $6B. In Search/Advertising, it would appear, Ballmer has finally wigged out. Either that or he's found a business in which he can lose more money, faster, than even the asinine amounts he's already lost on Xbox, MSN, IPTV, etc. - which is really the same thing.

Recall that just a few weeks ago, it was DoubleClick that was the target of his addled affection. But we know - or at least think we do - what happened there; MSFT offered to outbid GOOG's $3.1B cash deal but DoubleClick backers opted for GOOG anyway. Then 24/7 Real Media became the target of his infatuation, but that went to WPP group for $649M cash (notice how everyone avoids stock these days?). Now suddenly aQuantive is the perfect fit, and all that fiscal responsibility that MSFT has been bragging about with each successive bidding loss these past few months is a thing of the past. Here's how Liddell describes this $6B purchase - the largest acquisition in MSFT history:

We're happy with the price we paid. We believe it's exactly the right company to buy so we're willing to pay the value we are paying today," said Chief Financial Officer Chris Liddell. "We will use the strength of our balance sheet when we think it's necessary to drive growth going forward.

Is aQuantive everyone else's leftover and a poor choice? No, it's an excellent company. Here's an overview of why (nice and timely call btw Briefing.com). However, it was also a great company last year, the year before that, the year before that, and the year before that - when incidentally it was trading at a fraction of the current market price and already on the radar of investment forums including MSFT's own Moneycentral (not to mention being right under MS's nose in Seattle). But just like in '00/'01, when Ballmer could and should have been using MSFT's [then] legendary cash pile to make a ton of smart accretive acquisitions for pennies on the dollar, he was too distracted. This time, instead of the DOJ, it was OSS, the Vista screwup, and fantasy delusions that GOOG could be caught any time soon and via an in-house only strategy. Well guess what? The latter has been a failure, as subsequent market share data makes crystal clear. And this expensive and rather desperate acquisition is proof positive that even Ballmer acknowledges it. So, once again, shareholders get to pick up the tab. And not just an already inflated tab (from around $8 several years ago, to <$30 before the DoubleClick deal, to ~$36 before the news Friday) , but a whopping 85% premium to that. As Warren Buffett says, "The best side to be on in a bidding war is the losing side". So why did MSFT management do the unthinkable and not only engage in, but win, a bidding war? Because they once again failed to proactively understand the market and competitive forces and thereby position the company advantageously and cost-effectively. But rather than refocus/regroup after this latest strategic blunder and consider why their largely me-too strategy has been a failure to date, they're just going to "double down" - using our money. And that's going to somehow "change the game". Such is the collective brilliance that we paid $1B in bonuses for.

As you can tell by now, my concern isn't just did MSFT overpay. While you can argue that it equates to less per sales dollar than say, Google paid for DoubleClick - and some supporters of the deal have - I personally have no doubt that MSFT overpaid by any reasonable accounting analysis:

aQuantive generates admirable free cash flow, but everything has a proper price, and Microsoft sure doesn't seem to be paying it here. Discounting likely cash flows, and assuming a huge growth rate of 30% a year for the next half-decade(before some minor cooling), I'd value aQuantive at $45 a share on the very high end. By my math, Microsoft is paying 54% too much, even if things turn out great.

In other words, based on the math alone, this deal might pay for itself sometime in the 2020's - right around the same time that Xbox gets to lifetime breakeven (maybe). Therefore, the critical issue for shareholders imo is having overpaid, can MSFT possibly make it work and how? Beyond the obvious financial obstacles discussed above, there are real business, integration, and strategic, concerns. For example, just this past week, the CEO of AQNT was citing their "independent" position as a core competitive advantage:

We think we can continue to win market share from DoubleClick as we have consistently over the past five years, and now we have the added opportunity of being the only independent player

Hmm, when you throw $6B around it seems that former deeply-held convictions can go out the window. However, for all except the brain-dead, it clearly was and is a major business consideration with unclear implications now that AQNT will no longer be "independent". So how is that going to be resolved and what impact will it have on AQNT's current and expected sales? More importantly, how is this addition going to possibly re-position MSFT's overall money-losing, distant #3 Search and Advertising business in such way that it can recoup that $6B and actually turn a profit on it? Oh, I forgot, current management never concerns themselves with that last part. There's a lot of talk about benefits outside of Search and Advertising for MS. To make it work financially, there almost have to be. But what are they? Is there a play here for Office? Servers? Tools? Will MSFT save some money by say, drop-kicking their current ridiculously bad advertising partners who have brought us the lackluster/non-existent Vista and Zune campaigns, replacing them with AQNT's talent instead? And does it seem odd that a company who's advertising generally sucks (MSFT), especially versus competitors like AAPL, thinks they can "win" in this particular space? Maybe Ballmer can help us out here. Let's look to him for some clarification on the strategy and business justification underpinning MSFT's largest-ever purchase:

The advertising industry is evolving and growing at an incredible pace, moving increasingly toward online and IP-served platforms, which dramatically increases the importance of software for this industry,” he said of today’s deal, adding that it, “represents the next step in the evolution of our ad network from our initial investment in MSN, to the broader Microsoft network including Xbox Live, Windows Live and Office Live, and now to the full capacity of the Internet. Microsoft is intensely committed to creating a thriving advertising business and to partnering closely with all key constituencies in this industry to help maximize the digital advertising opportunity for all.

Have you ever heard more meaningless, content-free, doublespeak in your entire life? This is the "next step" in MSFT's overall unprofitable Online and H&E strategies? Wasn't the next step supposed to be making money - finally? How is an extra $6B of costs going to do that exactly? I mean, is all this just about demonstrating "commitment" to this space? With that kind of reckless financial stupidity it's Ballmer who should be committed - to an asylum. And how will the net result be different from the abject failure to date if we're stuck with the same me-too strategy? As one report noted while discussing why MSFT has lost its innovative edge:

In the old world of technology, Google's ad push might have been met with the announcement of a killer technology, possible for something unrelated, or even more likely for some new online ad-serving technology that lets Microsoft push commercial content simultaneously to online, TV, podcast, radio and for output in various print and display venues. That didn't happen.

I agree. What is the plan? If it's the one evident currently - namely to beat GOOG by copying them only slower - then Ballmer is out of his mind. There is NO hope that is going to happen in the short term. Instead of focusing on a competitor, MSFT should concentrate on a customer niche that it can dominate and then build from there. For example, I have long argued that MSFT should try (directly and in partnership) to position itself as the most-effective vehicle for advertisers. In other words, not necessarily the biggest (duh), but the one who has the deepest market knowledge - at least within some core verticals - and the one who can provide the best effectiveness and tracking for advertisers. Even if the latter means - gasp - placing advertising across competing networks. Right now, online advertising is a free-for-all. But over time advertisers will gravitate - and pay a premium - for those entities who can demonstrate the most bang for their buck. AQNT's deep expertise could help in that, but you need a focused strategy first. Otherwise, whatever they bring to the table will be quickly diffused across too many conflicting efforts - like ignorantly trying a frontal assault against a dominant entrenched competitor like GOOG. Why even continue making this a "we vs GOOG" battle when it's clear MSFT isn't in the same league? If you were relatively new to golf and way down the rankings, would you constantly reiterate your goal to beat Tiger Woods? Does it serve shareholder's interests to have the market constantly compare every misstep or minor victory against the backdrop of GOOG and that goal ? It doesn't. We'd be far better off if management made that clear, stopped blindly responding to everything GOOG does, and focused instead on executing their own strategy with more realistic short-term goals - like becoming a relevant and profitable #3.

Meanwhile, MSFT throws in another re-org for good measure. I guess internecine battles are a nice break for the troops from getting killed by competitors.

BTW, If there's some good financial news relating to the AQNT purchase it's this:

The company said the deal would add revenue and operating expense in fiscal 2008, but said it will not change its outlook for operating income or earnings per share next year.

How that will be accomplished is anyone's guess since the interest lost on the $6B - plus integration costs - should eat up any profit AQNT was set to deliver (assuming customers don't balk at the newfound lack of independence) and/or merger cost savings that can be eked out short-term. Presumably, MSFT will be making cuts elsewhere in order to create that result. That said, expect buybacks to slow or even stop on the back of this - at least for several Q's. Otherwise, unless they sell some of their LT investments to help cover this (like maybe Comcast shares now that the latter dumped MS's TV guide?), cash + ST investments will dip below $20B - which would be contrary to Gates' stated preference to go a year w/o any revenue if need be.

Bottom line, AQNT is a great company and should have been acquired years ago while it was still cheap - and when MSFT had already committed 110% to this area. That's what a smart, proactive, management team would have done. Instead, at this price, the sun, wind, and moon, will have to align in order for it to make financial sense. Translated, the current management team who have a brutal record of successfully integrating acquisitions and have shown no aptitude yet in beating YHOO, far less GOOG, are going to have to do BOTH and then some to make it a wise investment.

However, yours truly has come up with the one way in which this deal can make perfect financial sense. Reviewing this must-read article, it's clear that AQNT's chief executive officer Brian McAndrews is a force to be reckoned with. And since MSFT is desperately in need of a new (non-inbred) CEO-replacement, maybe he's it. After all, not only did he just out-negotiate Ballmer six ways from Sunday, but over the past 5 years he's managed to reward his shareholders with a 2000% increase in share price versus ~14% for MSFT. $6B for aQuantive? Far too much and almost impossible to reconcile financially. On the other hand, $6B for a new (capable) MSFT CEO who can substitute winning strategies and execution for empty bravado, dubious "investments", and irresponsible spending? Priceless.


Related:

Articles against the deal:

• Endless (do a search) - although the market itself is taking it well so far.

Articles for the deal:

• Why Microsoft's purchase of Aquantive is So Smart

Update:

Found two more positive articles on the deal - they're proving to be more elusive than MSFT ship dates.

• Microsoft Hits A Walk-off Home Run with AQuantive acquisition (courtesy Windows-Now.com)
• Why AQNT is worth 2 Times DCLK (courtesy InsideMicrosoft)

Update #2:

Good thing I said the market was taking it well "so far". Berkowitz spoke at a JP Morgan conference today and got killed during the Q&A. Perhaps that's why the stock was off so visibly. Listen to the linked webcast or check out this for some excerpts:

• Microsoft exec: aQuantive deal more of a 'merger'