Is MSFT overpaying for YHOO?

Mish has a piece that claims as much. I have some background covering internet stocks from my time as a hedge fund analyst. Thought I’d add my commentary on the deal.

[Incidentally, I owned YHOO shares...precisely because a MSFT deal seemed imminent.]

Two questions: Was this the right move for MSFT? Yes. Did they overpay? Perhaps, but they’re not paying as much as you think.

MSFT is getting killed on the internet. Computing is moving inexorably from a PC-based ecosystem to an internet-based one. GOOG is the one company that has figured out a way to turn internet traffic into cash. Take a look at the following chart, courtesy of Alexa, which lists the top 20 largest websites in the world in terms of eyeballs.

[Incidentally, I work part-time as the Controller and Business Analyst of Fotolog, #14 on this list, which was recently purchased by Hi-Media]

There are a couple key points to realize when looking at this chart…..GOOG not only owns 5 of the top 20 websites by traffic, they’re one of two companies that generate greater than $1 billion of revenue, strictly from internet traffic. The other one is YHOO, but YHOO trails significantly…..in revenue, profitability and search (the most profitable kind of) traffic. Still they are the other dominant internet company.

None of these other sites, including the ones that GOOG owns, generates $1 billion of revenue. That secret sauce gives GOOG immense market power. And with initiatives like Google Docs, desktop search and even gmail, they’re encroaching on MSFT’s turf. The Windows/Office franchise is hardly at risk in the short-term, but MSFT ignores the internet at its own peril.

Buying YHOO gives them scale (domestic and international), technology, people. At this point, MSFT can’t hope to build this on their own. GOOG’s/YHOO’s lead in terms of traffic and technology is too large.

On to the second question, did MSFT overpay? First of all, many are basing their criticism of the valuation on YHOO’s P/E ratio. At $31 per share, against $0.46 of expected earnings in 2008…..the P/E seems very high at 65…..

This is a highly simplistic method of valuing the company. First of all, it gives YHOO no credit for the value of its stakes in Yahoo Japan and Alibaba. Put together, the two investments are worth $4 per share, a not trivial amount. But since their earnings aren’t consolidated on YHOO’s financial statements, the “E” in P/E does excludes them. Using P/E is misleading because the “P” includes the value of Yahoo Japan and Alibaba, but the “E” does not.

A more accurate valuation method would be to compare Enterprise Value with Cash Flow. EV measures the value of the company after factoring in the value of cash, investments and debt on the balance sheet. EV represents what an acquirer would actually have to pay to buy the company.

If you were buying a used car for $2000, but it came with $500 cash in the glove compartment, you’d be paying $1500 for the car on a net basis. Not $2000. Now what if you still had to make payments on the car? Say another $2000 over five years. Then the true value of the car, i.e. the amount you’re paying, would be $3500. $2000 of equity + $2000 debt - $500 cash.

It’s the same idea with a public company. If you buy all the stock, you also buy the debt, the cash on the balance sheet and any investments that the company controls. If YHOO is a used car, the cash and investments in the glove box far outweigh the lien. Using the P/E valuation method completely ignores this.

Factoring in YHOO’s cash, and its investments in Yahoo Japan and Alibaba, MSFT is paying closer to $26 billion, not $42 billion.

And net income per share, commonly referred to as EPS, is not necessarily the best method to measure the cash generated by the business. Cash Flow is best for that. And it’s a simple calculation. Just look at the Cash Flow from operations for a company and subtract capital expenditures.

Pointing to the P/E ratio as evidence that MSFT is overpaying is misleading. Better to look at EV/CF. The ratio of EV to CF is a third the ratio of P to E.

If you factor in the $1 billion of cost savings that MSFT is talking about the valuation is even more compelling. $1.0 billion of savings would add $650 million to the bottom line (assuming a 35% tax rate). If we assume, therefore, that YHOO’s core business can generate $2.0 billion of cash flow per year, then MSFT’s offer is closer to 13x cash flow. That’s close to a steal for a company with assets and a brand as valuable as YHOO’s.

Just to recap: MSFT needs to do this to have a hope of competing with GOOG on the internet. Yeah, they are in panic mode; given the headstart GOOG has, they have to be. And yeah, the deal may not be executed well; nothing says MSFT is going to integrate YHOO successfully or take share from GOOG.

All of that said, this is still the right strategic move. And MSFT isn’t overpaying to the degree many suggest. If you factor in YHOO’s cash and investments, YHOO is a bargain at $31.

Indeed, given the strategic importance of this deal for MSFT, YHOO shareholders should hold out for more…..

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