Brexit

July 25, 2016

Britain decided to leave the European Union in what was clearly a shock to the markets. A consensus put the possibility of ‘Brexit’ at 9% a mere few hours before the EU Referendum took place on the 23rd June. As results started flowing in, so did the markets tumble. Several index futures including the S&P and Stoxx were down 5%, hitting their lower limits for the day. The pound took a massive beating falling to a 31-year low. Brexit came at a time when markets have already been struggling due to a weak global economy and has added to the prevailing uncertainty.

Even though Indian stocks moved in tandem with the global risk-off sentiment driven selloff in stocks, the market has been relatively resilient in the immediate aftermath of the result, thanks in no small part to the rock solid fundamentals. That said, it is expected that emerging markets will struggle to attract capital. The uncertainty surrounding the economic implications of Brexit has caused money to move to safe havens. The biggest worry about the Brexit vote is that it has opened a Pandora’s Box. Emboldened by the Brexit outcome, groups opposed to the EU membership in other European countries have already started demanding their own referendums. Far right political groups and parties in countries such as France, Spain and Netherlands have already called for referendums and the public discourse surrounding an exit from the EU is slowly gathering pace with the increase in violent attacks in the European states. The immediate impact of Brexit and growing clamour from other nations is an increase in risk aversion when it comes to investing.

Gold

Gold had been trading in a bullish trend since the beginning of the Brexit fear – trading above 1300 now

Risk aversion was immediately visible with gold rallying 5% while oil fell by 5%. Among global currencies only the US Dollar and the Japanese Yen appreciated, strengthening considerably, due to their perceived safety. Currency depreciation is further expected to increase risk aversion. Bullion which has been trading in the 1200 – 1300 range since the start of the year saw an immediate jump, going past the psychological resistance at 1300 and has been trading over this for the past four weeks. Oil, which has been struggling in 2016, has noticeably reacted to Brexit and is currently trading in the low 40s. EURGBP has hit a two-year low, trading below 1.2000, for the first time since early 2014. British imports have just become about 10% costlier, a rather significant number! With the financial industry facing a very tough year in 2016, Brexit could not have come at a more inopportune moment.

EURGBP

EURGBP moves from 0.7650 to 0.8300 in a few days, a depreciation of more than 10% for the GBP

Among other uncertainties, the most significant will be those surrounding the Free Trade Agreements (FTAs) and the discussions around trade and investment with emerging markets such as India. The EU has played an important role in the formation of bilateral treaties for its member states. India’s FTA talks with the EU, including trade and investment, are now bound to go forward under the assumption that the frameworks drawn will not include the Britain, even though the divorce won’t be final till 2017, at the very least. India is also a significant exporter of capital to Britain. It is quite likely that India will need to take stock of its bilateral agreements with the UK separately. These factors are likely to affect the GDP growth rate with many banks dropping their forecast for India’s GDP growth rate in the last few days, with the most significant being IMF’s downward revision from 7.5% to 7.4%. While the direct trade impact on the rupee is limited, global risk could weigh down on the rupee in the short term.

While the uncertainties had an immediate impact on the markets, there are significant arguments to suggest that Brexit could prove to be positive to the Indian economy and Indian markets by extension, in the long run. As per EU rules, an EU member can only recruit a non-EU citizen unless there is talent shortfall. Brexit is likely to be a boost in the opportunities available for Indians in the UK. Britain is also expected to look outside the EU, specifically targeting India, China and the US with respect to stronger trade ties, as it prepares itself for the split from EU.

FTSEvsSX5E

FTSE 100 (Candle) has been outperforming SX5E (green line) since the initial concerns immediately post Brexit

Turmoil in the financial markets is expected to persist in the face of these uncertainties but the perception is that the risk-off sentiment that has scared investors towards safer assets is temporary. Markets have adequately recovered from the shock in the last four weeks. UK’s benchmark FTSE 100 has, in fact, outperformed the Eurozone benchmark SX5E (Stoxx 500 Euro) since the initial drop immediately post Brexit. However, it is likely that the negotiations and potential developments discussed above could lead to further volatilities and investor fear. Policy responses will need to take these into account.

 

Written By –

Ravi Musti


Microsoft acquisition of LinkedIn – Demystifying the Network

July 5, 2016

INTRODUCTION

The mega US$26bn acquisition of Linkedin by Microsoft, which will see world’s largest professional cloud joining hands with world’s largest professional network has caught the attention of users and professionals alike. Through the medium of this article, we attempt to break down various facets of the deal and try and make sense whether the acquisition is strategically and financially attractive for both the companies.

OVERVIEW OF THE TRANSACTION

FINANCIAL OVERVIEW

The all-cash transaction of US$26bn, which is expected to be financed primarily by debt will see Linkedin shareholders receive US$196 per share. The acquisition is the biggest in Microsoft’s history (Figure 1). Post regulatory approvals in the US, the EU, Canada and Brazil and with no competing bids expected because of the sheer size of the deal, the transaction is proposed to close by the end of the calendar year 2016.

Figure 1: Microsoft’s biggest deals

Figure-1

Post announcement of the deal, share prices of Linkedin surged by 47% to US$191.21 while share prices of Microsoft fell by 2.6% to US$50.14

STRATEGIC OVERVIEW

Microsoft dominates the traditional workspace activities by offering a wide array of tools and is perceived as a ‘go to’ place for executing work; however, it has very few tools which connect different people electronically as they work (see Outlook and Skype). Through the acquisition of Linkedin, Microsoft seeks to encompass the entire workspace of an individual / corporate by virtually putting ‘desktop work’ on network and facilitating seamless interaction between the space inside and outside of the office.

Further, the deal helps Microsoft enter the consumer web boom – an area dominated by Google and Facebook while at the same time, ensuring it sticks to its core competencies (with Linkedin connecting office professionals). To leverage on the existing brand, Linkedin will retain its distinct brand, culture and independence with Jeff Weiner continuing as the CEO and reporting to Satya Nadella.

Speculations were also rife that similar technology / social networking companies may be acquired by the larger players having huge reserves of cash. Some of the reasons why such target companies look forward to being acquired include softening of the economy and inexperience in scaling up. Twitter, Groupon, Fitbit and LendingClub are some of the potential target companies; for that matter, share prices of Twitter jumped by 9% on news of the Microsoft-Linkedin deal.

POTENTIAL UPSIDES

Integration of Core Competencies
Figure-2Linkedin is proposed to be integrated into various Microsoft Office tools which will make learning of the outside professional world convenient and simultaneous. Quick profile checks before meetings, getting to know of live feeds and integration of information in silos are some of the major benefits.
Data Analytics and Artificial Intelligence
Figure-3Microsoft could build Linkedin into a major customer relationship manager software such as Salesforce.com with the current analytics prowess at its disposal. The analytics and live feed provided by Linkedin can also be used in Microsoft Dynamics CRM. Cortana, the digital assistant provided by Microsoft will seek to manage professional life better with more information available.

Boost to the Stagnating Business of Linkedin

Linkedin shareholders received a premium of nearly 50% of the share price (price before the deal was announced); however, the share price at US$196 is still at a discount of 28% of the share price high that it had reached in early 2015. This has mainly been account of failure to meet expectations and stagnation in use of the platform.

Figure-4,5

With Linkedin now in a position to gain access to the large platform and distribution services provided by Microsoft, it seems to be a winning situation for Linkedin as it can leverage Microsoft’s resources which is also reflected in the rise in the price of its stock after the deal announcement

Other Major Benefits

  1. Microsoft is seeking to move more into the corporate customer segment rather than the conventional regular customer segment. Acquisition of Linkedin helps Microsoft gain valuable insights into the corporate world (such as impending project work)
  2. Linkedin had acquired a company (Lynda) that facilitated online learning and education. Integration into Microsoft products will enable greater accessibility and awareness of such programmes
  3. Cost synergies to the tune of US$150mm per annum expected by 2018

HOVERING CONCERNS

Operational Concerns – Microsoft’s Track Record of Acquisitions

Microsoft has been pretty infamous in dealing with many of its large acquisitions, especially the ones which are outside of Microsoft’s core domain. After the acquisition of Nokia, Microsoft has been busy firing Nokia employees as part of restructuring and has written down value of its investments. Microsoft actually wrote down this acquisition by $7.6 billion a year later about the same price at which it had acquired Nokia ($7.2 billion).  Skype promptly lost ground to better options such as Facebook and WhatsApp. Online advertising firm aQuantive, acquired to match Google’s advertising business failed because Microsoft did not know how to run it. Yammer has been relegated to an insignificant position in Microsoft.

Financial Concerns

Many experts have commented that the deal value is on the higher side. The consideration implies that Linkedin is paying US$247 for every current active user of Linkedin, which is a pretty steep amount in itself considering the revenue model of Linkedin. Thus, it is necessary that users keep on getting added on to the platform. However, there are concerns around the addition of new users given that Linkedin already has a registered user base of 430mm.

Behavioral Concerns

Users might be concerned about the use of information available on one portal on a different portal – something which even Mr. Nadella has acknowledged. Also, companies might not approve of employees using a social networking site during work hours, even though it might be useful.

Debt Financing

Inspite of the healthy cash reserves at Microsoft’s disposal, the use of debt for financing of the deal has raised certain eyebrows. Microsoft, one of only 2 companies in US with a AAA credit rating might see a possible downgrade in its rating by Moody’s with its gross debt increasing to 2 times EBITDA.

VALUATION

The larger opinion has been that at US$26bn, Microsoft has overpaid for Linkedin. The valuation was arrived at using 8.1x trailing 12 months revenue and 6.7x forward 12 months revenue, whereas TechCrunch has estimated that average SaaS revenue multiple for a publicly traded company is 4x – 6x.

We also ran an independent DCF valuation of Linkedin as a standalone entity (i.e. without considering the possible synergies on account of the acquisition) but reflecting risk profile of LinkedIn and its peers with an implicit assumption that over the time LinkedIn’s capital and the cost of capital will gravitate towards industry average. We arrived at price per share US$89.1 for LinkedIn (pre synergies). We have also provided a sensitivity analysis of our DCF with respect to the assumptions regarding WAAC and terminal growth. Our DCF analysis price is at a 35% discount to the pre-acquisition price of the LinkedIn (5 month average price before the acquisition announcement).  Microsoft’s acquisition at US$196 represents a step premium of 120% over the fundamental price of the LinkedIn.

Table-1

The value of the investment thus arrived at was US$11.50bn indicating that the present value of the synergies that must be generated on the deal must be US$14.50bn. A back of the hand calculation shows annual post tax synergies till perpetuity must be US$786mm to justify the deal consideration, which is way higher than the US$150mm annual cost synergies expected by Microsoft. The deal has to accordingly generate sufficient revenue synergies for the purchase price to be justified.

Microsoft expects the deal to be EPS accretive by FY19. Our analysis, however expects the deal to be accretive only by FY20. Accretion improves with smaller offer premium. However, premium below 30% would have been highly unlikely to incentivize LinkedIn shareholders.

Table-2

Based on the above calculations, the deal does seem to be risky for Microsoft in terms of generating its required returns and it might not have been a bad idea for a certain proportion of stock in the purchase consideration to share the risk so arising because of the uncertainty. This is exactly what Facebook did in its $22 billion acquisition of WhatsApp which was financed 82% by stock. In spite of the above calculations which are derived using rational assumptions, the Linkedin bet does not seem to be a bad one because of the quality of its user base as explained below.

Figure-6

Figure-7

CONCLUSION

The deal has evoked mixed reactions from different quarters. Credit Suisse sees the potential for strategic synergies between the two companies. UBS says the deal makes strategic sense but wonders whether there will be a culture clash between Microsoft’s more grown-up culture and the younger Linkedin. BMO Capital Markets, on the other hand suggests Microsoft could have done better for US$26bn. As interesting it will be to see the future paths of the merged entity, the deal could also widespread implications on consolidation in the global technology sector.

EXHIBITS AND REFERENCES

Exhibit: Brief Profiles of the Companies

Figure-8

References

Annual Reports of Microsoft and Linkedin, Microsoft Investor Presentation, Bloomberg, Reuters, The Economist, News runs, Data provided by Damodaran (NYU Stern)

 

Written By –

Mohit Pimpalkar

Yash Baheti