Competing for Customers and Capital

It's A Vision Thing

Microsoft's (MSFT) grab for Yahoo! (YHOO) isn't so much about beating Google (GOOG) in search-advertising. It's more about beating Google to the online distribution of desktop applications. And according to Professor Michael Cusumano of the MIT Sloan School it's a bad move: "Rather than acquire Yahoo, Microsoft should pursue SAP." This quote appeared in an article by Professor Randall Stross of San Jose State University. Professor Stross, who also edits the Digital Domain in The New York Times concludes that:

A few dozen well-paying Fortune 500 customers may actually be more valuable than tens of millions of Web e-mail “customers” who pay nothing for the service and whose attention is not highly valued by online advertisers.

His thought reinforces the idea in Yahoo's Audacious Option that Yahoo and Adobe should join forces to challenge Microsoft in the battle for desktop advertising. I first became aware of potential for desktop advertising on February 12, 2009 when I read Kevin Maney's article A Tangible Reason Microsoft Needs Yahoo when he asked:

Want a glimpse of Microsoft's future without some radical shift like buying Yahoo? Take a look at this piece entitled Forget Word: Thirteen Online Word Processors.

But buying Yahoo won't stop Google and the others from attacking its desktop franchise from all sides.

Near the top of Kevin Maney's list was a short description of Adobe's (ADBE) Buzzword. I'm writing this article in that online application right now. Here's a screen shot of my monitor as I write:

Look at all that gray space to the right of the document and in the top navigation bar after the Help button. Now imagine monetizing Yahoo's 500 million eyeballs with these now empty spaces around Buzzword and other ODP's (online document processors) coming down their pike. This, coupled with Adobe's history of attempts to monetize Yahoo's mass audience, is what tipped me off to the idea of online desktop-advertising as a new and untapped space that's quite unlike online search-advertising.

Who will be the winner of the coming battle for desktop-advertising? Now one knows. What we do know is that the right enterprise marketing strategy could tip the scales. After a friendly merger Yahoo and Adobe could lead the way with free applications, fat margins and mass distribution.

FREE APPLICATIONS

Here's what Shantanu Narayen, the new CEO of Adobe, said about their decision to give away the Mother Lode in 1993:

When we first launched the Adobe Reader, we charged for it. Adoption was slow. The problem was that there wasn't enough of an incentive at the time for people to purchase it. Yet, proliferation of the Reader was critical in order for Acrobat to catch on. 

We went back to the drawing board to re-think our strategy and ultimately decided to distribute the Reader for free. This was a significant policy shift and a radical approach at the time. The move was a controversial one inside Adobe ... many didn't believe in the idea of giving away such sophisticated technology. It was a strategic decision to sacrifice revenue in order to make the Reader universal and establish PDF as a standard. Now it's a major competitive advantage for the company. It drives the adoption of our [other] products ...

Adobe has since built their businesses by giving away sophisticated technologies. Here is what the company says about open standards on their web site:

Adobe's core business strategy is to drive growth through broad adoption of its technologies, and an open approach has always been an important part of that strategy. Throughout its 25-year history, Adobe has been an industry leader in open approaches with technology. 

Yahoo! gave away all of its sophisticated technologies in the hope its mass audience would pay off in online advertising. And that's just what happened, until Google spoiled its party. Can Yahoo and Adobe regain the high ground?

FAT MARGINS

In the audio slide show on Enterprise Marketing Expenses based on Chapter 4 in my book Competing for Customers and Capital I advise the reader that:

Gross margins rule in enterprise marketing.

In addition to offering free applications like Buzzword to prime the pump in market development, the merger of YHOO and ADBE would produce a new enterprise [YADO?] with sufficiently fat gross margins to challenge Microsoft and at the same time trump Google in the coming battle for desktop-advertising.

As this table shows, YHOO is on the losing end of the gross margin stick running well below Google's 60% margins. But ADBE with its gross margins in the 90% range dominates even MSFT. More important are the 70% YADO gross margins that a merger would produce.

MASS DISTRIBUTION

Now we come to the final keystone in YADO's desktop advertising strategy: free applications demand millions of eyeballs. And Yahoo! has 500 million of those. The vast majority of which are not locked-up behind corporate firewalls. Instead, these eyeballs belong to your Uncle Jim and Aunt Sue.

And guess what, Aunt Sue and Uncle Jim don't need all the mystifying functionality embedded in Microsoft's Office Suite. They can get buy just fine with only five fonts rather than the three hundred or so they are forced to buy in MS Office.

Ever wonder why these isn't a Microsoft Home edition? Actually, there is. It's called Microsoft Works. It's only $99 and it's based on Microsoft Corp.’s "Trustworthy Computing Initiative:"

Microsoft® Works Suite 2006 is an incredible value, integrating six complete Microsoft software programs — Works 8, Word 2002, Encarta® Encyclopedia Standard 2006, Digital Image Standard 2006, Money 2006 Standard, and Streets & Trips Essentials 2006 — into one comprehensive package. With the new suite on their home PC, families can get more stuff done quickly, from tracking and paying bills to managing to-do lists, so they can spend more time enjoying the things they want to do such as taking a vacation or watching their favorite sports team. 

As if that's not enough the site goes on to assure us that the Works Suite 2006 includes full versions of the six popular Microsoft software titles!

But, guess what? Uncle Jim and Aunt Sue don't need an integrated suite of heavy-handed word, number, image and slide processors even for the unbelievable price of $99. Plus the cost of paying for the Computer Professor's CDs to learn how to use them.

Aunt Sue and Uncle Jim don't mind if advertising pays for their word processor any more than they mind that it pays for their email accounts and favorite TV shows. By the way the same probably can be said for a majority of their nieces and nephews who are now in high school and college. To paraphrase the opening comment by Professor Stross:

Tens of millions of online Buzzword “customers” who pay nothing for the service but whose attention would be highly valued by Yadobe are worth as much -- if not more -- than a few dozen well-paying Fortune 500 customers!

ITS A VISION THING

Those of you reading this post who have followed the 60 other articles I've written in my series on Competing for Customers and Capital may be wondering why I haven't taken this analysis the final step. If so, you may be thinking: Where's the prediction of Yadobe's closing stock price on December 31, 2017? The reason I haven't is that sometimes an enterprise marketing strategy goes beyond the reach of numbers. Then it becomes a vision thing.

Thanks for visiting. As always I welcome your comments.

~V

An Audacious Option!

“Nobody would pay 50$ for a stock worth 18$.” This pithy comment was directed at Microsoft Massively Undervalues Yahoo! published here last week. The comment was motivated by this conclusion:

… [Yahoo!] optimal revenues of $13.4 billion would point to a market cap of around $78 billion based on a value/revenue ratio of 5.81. With 1.39 billion shares outstanding this suggests a price in the mid $50 range.

What are “optimal revenues?” Those are the revenues Yahoo! would generate if the earnings from the last sales dollar were equal to the cost of producing it. Or, in microeconomic-speak, the point where marginal revenue equals marginal cost. I apply this theory to the analysis of financial accounting data for public firms in my book Competing for Customers and Capital. Competing in a space with Google and Microsoft over the most recent four quarters Yahoo’s optimal revenues were nearly double its actual revenues of $6.8 billion.

Most of the pundits, including the Deal Professor at the New York Times, agree that Yahoo! has limited options:

Throwing yourself on the mercy of Microsoft not to go hostile appears to be another loser of a strategy. And while you can find some tie-up or other maneuvers to stall Microsoft or make any acquisition more expensive for them, it doesn’t look good. We eagerly await your next move given your limited options. Surprise us!

How could Yahoo’s CEO dramatically change the direction of his company? Certainly not by joining Microsoft to compete with Google in a lost battle for leadership of the search- advertising market. But maybe by competing with Microsoft in the battle for your desktop. My analysis led to these questions:

In several years could Jerry Yang and Shantanu Narayen lead their merged companies to challenge Microsoft on the desktop? And if they could, what might be the value of this company?

HAVE YOU HEARD THE BUZZ[WORD]?

On February 12, 2009 Kevin Maney published this article on Seeking Alpha: A Tangible Reason Microsoft Needs Yahoo. He began that post by saying:

Want a glimpse of Microsoft's future without some radical shift like buying Yahoo? Take a look at this piece entitled Forget Word: Thirteen Online Word Processors.

But buying Yahoo to protect the desktop franchise will only marginally broaden the moat Microsoft has built to maintain control of end users. It won't stop Google and the others from attacking its desktop franchise from all sides.

Near the top of that list was a short description of Buzzword. Clicking on this link sends you to a preview. An unexpected touch is that this preview document is open for alternation so you can test its functionality online. Among the apparent advantages of Buzzword are the ability to collaborate with co-authors and an extremely friendly user interface. Their UI was friendly enough to motivate my giving it a try. As a result I wrote this post in Buzzword.

ALREADY PARTNERS

Adobe has been searching for ways to monetize Yahoo's eyeballs for several years. On October 25, 2004 David Becker published Yahoo, Adobe team on search:

The companies said in a statement that they would work on a number of joint projects, including the creation of an online service to convert Web content into PDF (Portable Document Format) files and a toolbar that would add access to Yahoo Search and other features to Adobe Reader, the company's free PDF client.

More recently the two companies created another project aimed at the search market. On November 28, 2007 they:

... launched Ads for Adobe PDF Powered by Yahoo!, an opt-in service that enables online commercial publishers to drive new revenue by including timely, contextual ads next to Adobe Portable Document Format (PDF)-based content.

These experiences working together, when added to their similar provenances and innovative cultures, provide the foundation for merger discussions:

The two companies are largely complementary in technologies and solution portfolios. Both work in the creation of Internet content. YHOO, however, lacks apps. ADBE, with its rich suite including Flash, Dreamweaver, and Acrobat, a portfolio of corporate customers and powerful developer community, would fill this gap.

ADBE would profit from YHOO’s immense distribution network. Such a broad and deep distribution channel could provide the linked companies the mass and depth to challenge MSFT’s dominance in the productivity apps market (Richard Lewis, personal communication 15feb08).

Jerry Yang might approach Shantanu Narayen (or Charles Geschke and John Warnoc) to initiate merger discussions off the record and under the media radar. Narayen may be the best bet to broker this deal since he, like the co- founders, is a technologist with a vision. In an interview following CEO Bruce Chizen's resignation Narayen said " ... we are one of three or four companies in the world who can make the Web experience better than it is today." I wonder if he considers Yahoo to be among those companies:

Narayen stated, in a 2005 Business Innovation Insider interview, that he admires Yahoo! as a company for its capacity to innovate. As President and COO, he drove Adobe's innovation and expansion into new markets (Richard Lewis, personal communication 16 Feb 08).

If he belives Yahoo! is one of those companies who can make the web experience better Narayen may be the right guy to run the merged operations.

500 MILLION EYEBALLS

Mr. Yang in his February 13, 2008 letter to Yahoo! shareholders stated that:

Yahoo! is one of the most recognizable and admired brands in the world. We have over 500 million users (nearly 1 out of every 2 internet users worldwide). Our goal is to grow visits to key Yahoo! starting points and properties, where users enter the Internet, by 15% per year over the next several years.

As the following table of Alexa data shows, Mr. Yang's goal is a stretch if it's to be reached through search advertising alone. Last week only 14% of visitors went to Yahoo! to search for something. Which pales by comparison to Google's 60% of visitors using search.

But the reason for Yahoo's top rank among internet users is due more to the number of page views per day (12.9) than to it's reach (27.85%).

VIRTUAL UBIQUITY

Recently Adobe made acquisitions that transformed it from a major player in the design space to an industry-wide challenger with a growing range of software products. For example, the company's acquisition of Macromedia, Inc brought:

... together some of the industry’s strongest software brands and most ubiquitous technologies, and accelerates Adobe’s strategy to provide a powerful software platform that scales from mobile devices to enterprise servers.

This broad product range represents an asset base unparalleled in the digital world. But more important in the motivation for a merger was Adobe's October 1, 2008 commitment to acquire Virtual Ubiquity and its online collaborative word processor:

Adobe Systems ... today announced that it has signed a definitive agreement to acquire Virtual Ubiquity and its ground-breaking online word processor, Buzzword ... [that] will ... enable fundamental improvements in how people collaborate on documents ...

HOW DO YOU LIKE THESE APPLES?

People spend a lot more screen time creating documents than searching for things online. Yahoo's email leadership is largely responsible for its leadership in page views per day. Yet email requires far less screen time than more elaborate documents. These documents require even more time than watching videos on YouTube!

As I type this I've become aware that a substantial chunk of my screen's real-estate is occupied by a gray panel immediately to the right of the page. And there's a black strip across the top of the screen immediately following the "Help" command that's also unoccupied. These provide perfect venues for targeted ads.

But, wait! Would I allow targeted ads to appear in my private Buzzword document processor? My first reaction is "No Way!" But on second thought, I allow Google to place its responsibly targeted ads in similar spaces around my personal g-mail page! The real value would be if those screen spaces were filled not just with Google-like AdWords, but with links to stuff that would be useful in writing this article. Like the latest price of the stock tickers that appear in this document. But this would:

Call for Google-styled "cloud computing" that delivers something of value to you beyond the application functionality ... collaboration and 6 GB of online storage might work...and would be a nice (free) competitor to Microsoft's Groove (Edward Strong, personal communication 15feb08).

Just think for a moment about monetizing Yahoo's eyeballs with the now empty spaces around Adobe's Buzzword and other ODP's (online document processors) coming down their pike.

WHO WOULD PAY $50 FOR AN $18 STOCK?

The the first two lines in the following table compare YHOO's actual with its optimal market share, sales revenue , cost of revenue , enterprise marketing expenses, and EBITDA for the most recent four quarters. In a strategic group with Google and Microsoft the company's actual market share was 8.4% compared with an optimal market share of 16.5%. Its actual sales revenues were $6.8 billion compared with optimal revenues are $13.4 billion.

That optimal sales revenue of $13.4 billion is what drove my conclusion that investors would price Yahoo! in the mid $50 range -- if management optimized enterprise marketing expenses at $6.7 billion. Yahoo's historical value/revenue ratio [P/S ratio] is 5.81. Assuming this historical multiple still applies, the company would be worth around $78 billion if it optimized earnings. With 1.39 billion shares outstanding that points to a price of $56.

The third line in the table above,+ ADBE, reports the results of simply adding YHOO and ADBE numbers together without any synergies or other assumptions. Their combined market share of group revenues jumps to 14.7% yielding sales revenues of $10.0 billion. Assuming the merger would earn Adobe's value/revenue multiple of 6.10 their market cap would be around $60 billion, or $44 a share. The bottom line in the table above +ADBE at Optimal sales of $14.39 billion leads to a share price around $63. These values pretty well bracket that mid $50 price.

BRIDGE MONEY?

On January 31, 2008 Yahoo! closed at $19.18 with a market cap of $26.66 billion. Last Friday it closed at $29.66 with a market cap of $41.23 billion. Could the $14.57 billion difference be used as "bridge money" by Yahoo! in negotiating a deal with Adobe.? Its market cap last Friday was $19.89 billion.

If investors priced the combined companies in the mid $50 range it would be a sweet deal for everyone. And Microsoft would be off the hook! What do you think?

Thank you for visiting. As always I welcome your comments.

~V

Yahoo is Massively Undervalued

Early Sunday morning February 10, 2008 Matthew Karnitschnig reported in his Wall Street Journal article that:

Yahoo Inc.'s board plans to reject Microsoft Corp.'s unsolicited $44.6 billion offer to acquire the Web giant, a person familiar with the situation says.

After a series of meetings over the past week, Yahoo's board determined that the $31 per share offer "massively undervalues" Yahoo, the person said.

The article goes on to say that “The company is unlikely to consider any offer below $40 per share …”

SOME BACKGROUND
This is my second post on the Microsoft-Yahoo! deal. The first Microsoft: Why Shell Out $45 Billion? published last week, investigated Microsoft’s financial dilemma. Compared with Google (NasdaqGS: GOOG) I found that Microsoft was overspending on Selling & Marketing in accordance with Gerstner’s Rule in High-Tech Industries: the cost per dollar [CPD] of revenues. I concluded that:

Like Eddie Foy, Jr. sang in the 1954 hit Broadway play The Pajama Game, 11¢ doesn't buy a hell of a lot ... till you multiple it by MSFT’s nearly $58 billion 2007 revenues. That produces an eye-popping net competitive redundancy of $6.367 billion … all of which is associated with MSFT’s Selling & Marketing expenses.

This post looks at the proposed deal from the perspective of the Yahoo! board using a sharper measure of enterprise marketing performance from Chapter 6 “The Rule of Maximum Earnings” of my book Competing for Customers and Capital.

YAHOO! FUNDAMENTALS
This analysis compares Yahoo’s actual to its optimal sales, expenses and earnings during the most recent four quarters. The actual values were taken from EDGAR Online I*Metrix reports. Optimal values were calculated from the financial accounting data. These theoretical values occur when a company optimizes expenses by earning exactly what it spent to produce its last dollar of revenue. The costs of producing revenues are described in my audio slide show “Enterprise Marketing Expenses.”

There’s a huge difference between enterprise Marketing, with a big M, and traditional marketing. In that audio slide show I define enterprise marketing expenses as …

… all the costs of the people and programs that influence how consumers, customers and investors think, act and feel about a company.

The following table reports Yahoo’s share of revenue, sales revenue, cost of revenue, enterprise marketing expenses, and earnings in a strategic group with Microsoft and Google. Yahoo! had not yet filed its December 2007 financial statements so its data are for the quarter ending September 2007.

Yahoo’s optimal share of group revenues was almost double its actual share: 16.5% compared with 8.4%. Optimal share would have translated into $13.4 billion in sales revenue compared with actual revenue of $6.8 billion.

Generating these additional sales would have required on the order of $2.7 billion in additional cost of revenue. In Yahoo’s 2006 financial statement, the management discussion said:

Cost of revenues consists of traffic acquisition costs and other expenses associated with the production and usage of the Yahoo! Properties, including amortization of acquired intellectual property rights and developed technology.
 
Traffic Acquisition Costs (“TAC”). TAC consists of payments made to affiliates who have integrated our search and/or display advertising offerings into their websites and payments made to companies that direct consumer and business traffic to the Yahoo! Properties (page 39).

This management discussion also reported the cost of revenues in 2006 was $2.676 billion. And TAC were $1.866 billion or 69.7% of revenue costs. This explains why Yahoo’s cost of revenue was more than twice those of Microsoft (20.0%). Unlike Microsoft, Yahoo! wholesales its solutions 70% of the time.

The values reported in this table assume the cost of revenue would continue to account for 41.3% of Yahoo’s nearly two-fold increase in revenues during the time it took to achieve this optimal level. In addition, to do this the company would have increased enterprise marketing expenses from $3.1 to $6.7 billion or about 115%.

MASSIVELY UNDERVALUED?
Optimal revenues of $13.4 billion would point to a market cap of around $78 billion based on a value/revenue ratio of 5.81.  With 1.39 billion shares outstanding this suggests a price in the mid $50 range. This strikes me as far enough above his offer of $31 a share to conclude that Mr. Ballmer did indeed "massively undervalue" Yahoo!. What do you think?

Thanks for visiting.

As always your comments are welcome.

~V

Steve, Why Shell Out $45 Billion?

Since last Friday the Internet has been abuzz with analysts’ reactions to Steve Ballmer’s letter to the Yahoo! board (NasdaqGS: YHOO) asking for quick approval of a buyout at $31 a share in cash or Microsoft stock (NasdaqGS: MSFT).

A broad sampling of these reactions was provided by Dan Gallagher in his MarketWatch technology column “Microsoft-Yahoo deal draws mixed reactions.” No fewer than nine analysts from seven companies weighed in on the deal just hours after it went public. They split about evenly between pro and con. One of those reactions struck me as speaking to the heart of the matter on two critical dimensions: synergies and integration (the emphsis is my own).

Although the synergies between the two companies, which Microsoft asserts are worth at least $1 billion a year, are certainly great, the merger also raises the question of how effectively they'll be able to continue operating during their integration. The online-advertising business requires significant levels of account service and even the perception of a diversion could wind up delivering business to their competitors. -- Andrew Frank, research vice president at Gartner Inc.

I’m not qualified to speak to the integration issue, which largely is a technical question, but I am able to speak to one important dimension of synergy. As Mr. Ballmer put it in his letter to the Yahoo! board "eliminating redundant infrastructure" inherent in the merged companies. The purpose of this article is to document the sources of competitive redundancies based on the latest financial accounting data.

18.8¢ AIN’T A HECK OF A LOT
18.8¢ does not seam like much until you realize it was at one time the difference between Microsoft and Google’s (NasdaqGS: GOOG) cost per dollar of revenue. On April 17, 2007 I posted an article “Microsoft’s $8 Billion Problem.” In that piece I concluded that:

It cost Microsoft 18.8¢ more to generate a dollar in sales than it cost Google. Multiply that 18.8¢ times its sales revenues and you find that Microsoft has an $8.3 billion dollar problem. That's how much the company was over-spending on enterprise marketing in 2006 compared with Google.

In that same article I introduced “Gerstner’s Rule.” In his book Who Says Elephants Can't Dance? Lou Gerstner laid out a rule of thumb on enterprise marketing efficiency. It's simple and revealing: How much does it cost to generate a dollar in sales revenue compared with your competitors? This is Gerstner's cost per dollar [CPD] rule: less is more. If you’re interested in how much CPD varies among companies see my May 11, 2007 article “Gerstner’s Rule in High Tech Industries.”

INSIDE ENTERPRISE MARKETING
There’s a huge difference between enterprise Marketing, with a big M, and traditional marketing. In an audio slide show I define Enterprise Marketing Expenses as …

… all the costs of the people and programs that influence how consumers, customers and investors think, act and feel about a company.

Fortunately the income statements of MSFT, YHOO and GOOG give us a pretty clear picture of all those expenses. The following table reports all the costs found inside the enterprise marketing expense [EME] category: Selling & Marketing [S&M], General & Administrative [G&A], and Research & Development [R&D]. These line items accounted for 53%, 16%, and 32% of MSFT’s total enterprise marketing expenses, respectively.

I colored EME a cautionary yellow because earnings occur only after all three expenses are covered. And I colored S&M expenses red because they often are the culprits in a company’s failure to maximize earnings. By the way, the approximately $12 billion that Microsoft spent on S&M included traditional marketing as well as sales force expenses. These data were downloaded from Edgar Online I*Metrix services. For MSFT and GOOG the most recent 4 quarters ended in December 2007, while YHOO’s ended in September 2007.

GERSTNER’S RULE
The basic data make a lot more sense when standardized using Gerstner’s Rule: in enterprise marketing less is more. The next table reports the cost per dollar [CPD] of revenues by source for each company.

Microsoft’s gross CPD (in the right-hand column) was $0.40 in December 2007. This compared with $0.46 in June 2006 (not shown). This represents a decline in Mr. Ballmer’s CPD of nearly 12% in 18 months. On the other hand YHOO’s cost per dollar increased 8% from $0.42 in June 2006 (not shown) to $0.45 in December 2007; while GOOG’s went from $0.27 to $0.29. But G&A expenses as well as R&D expenses per dollar sales were comparable across all three companies. It’s Sales & Marketing expenses that raise the red flags for MSFT and YHOO.

IT’S SELLING & MARKETING EXPENSES!
The next table reports the cost per dollar for MSFT and YHOO net of GOOG’s cost per dollar by source. Notice MSFT posts a net competitive advantage on G&A expenses as well as R&D costs per dollar revenue.

Still there’s a bothersome -12¢ CPD in net Selling & Marketing expenses. Not to mention YHOO’s net CPD disadvantage of -16¢, most of which is also attributable to Selling & Marketing expenses.

THE PAJAMA GAME
This final table brings the analysis back to the central question: What are the potential synergies to be found in this merger of equal over-spenders? Like Eddie Foy, Jr. sang in the 1954 hit Broadway play The Pajama Game, 11¢ doesn't buy a hell of a lot ...

… till you multiple it by MSFT’s nearly $58 billion 2007 revenues. That produces an eye-popping net competitive redundancy of $6.367 billion … all of which is associated with MSFT’s Selling & Marketing expenses. To be sure that’s nearly $2 billion less than the $8.3 billion dollar competitive redundancy from 2006 mentioned above. A big improvement, but this just begs the original question.

WHY SHELL OUT $45 BILLION?
Dan Gallagher’s MarketWatch technology column “Microsoft-Yahoo deal draws mixed reactions” also quoted Leland Westerfield as saying:

Microsoft would ultimately need to sweeten its initial offer price …
(BMO Capital Markets)

Why shell out $45 billion or sweeten the deal more for a house in the country – pardon the garish play on words - when the goal should be to fix a problem in Mr. Ballmer’s own back yard? What do you think?

Thanks for visiting. As always your comments are welcome.

~V