When Patriots' quarterback Tom Brady heaved two Hail Marys with seconds left in the Super Bowl, I flashed on Steve Ballmer's hostile bid for Yahoo!. Microsoft, like Yahoo!, lost its way in the Internet search advertising sector. Google clutched the lion's share of this burgeoning business--which, down the road, is where most advertising is destined to land.
Microsoft (nasdaq: MSFT - news - people ) can afford to throw money at its problems. Free cash flow after dividends runs at an $11 billion clip. Over five years, they invested (and lost) over $5 billion in the X-Box initiative in computer games before it turned profitable this year, taking a swing of almost $1 billion in six months.
In 2004, Microsoft distributed $32 billion in dividends to its shareholders and put a regular payout on their stock, presently yielding 1.44%. There's $22 billion in cash on their balance sheet.
The MSN search business, which competes with Google (nasdaq: GOOG - news - people ), is an embarrassment. Revenues run over $3 billion annually, but Microsoft is losing money at twice the rate it was a year ago, at a $1 billion pretax clip in fiscal 2008. The losses entail spending to improve their search engine and the data centers needed for support. For the long term, Microsoft needs to protect its basic software business with competitive online services, or sit back and watch it erode. Serious stuff.
What is Microsoft getting for $44.6 billion? If you subtract Yahoo!'s (nasdaq: YHOO - news - people ) monetized value of Yahoo! Japan and AliBaba, worth $9 a share, Microsoft is paying 18 times Earnings Before Interest, Taxes, Depreciation and Amortization for Yahoo!, not an outlandish multiple. Google sells at 16 times EBITDA, so the control premium for Yahoo! is minimal. Yahoo! earns approximately $700 million, but Microsoft can't earn more than 2% on its cash in Treasury bills, so deal dilution is pennies per share.
Tech houses like Microsoft make dozens of add-on acquisitions, because frequently, it's cheaper to buy product primacy than to build it. The threat to invade a small operator's back yard is enough to get them to the deal table. Acquisitions should be treated as comparable to capital spending.
The record of broadly based corporations doing mega deals, however, is dismal. Time Warner (nyse: TWX - news - people ) wrote off $54 billion on its AOL gambit; they bought a failing Internet operator that couldn't renew itself. In practice, big deals normally lead to underperformance for the buyer's stock, as the market anticipates integration problems unless there are major cost-cutting synergies.
The Microsoft and Yahoo! networks won't be combined, so any savings come in engineering and research productivity, which is difficult to model in dollars. After all, Google's innovation capacity is a moving target.
Companies with near-monopoly positions on the board are cash machines. Google holds $14 billion in liquid assets, with free cash flow running quarterly at $1.2 billion, up from $900 million quarterly last year. Net revenue growth exceeds 50%, but is decelerating slowly year over year. The current run rate for revenue is $13.6 billion annualized. Google is an octopus--with stretchy tentacles.
What's wrong with Google? The market lopped off a third of the company's price since its peak in November. First, there's analysts' ciphering to contend with. Google's fourth quarter missed earnings by a couple of pennies. There was concern as operating profit margins eased from 31% to 30%. Disappointment at the margin for any stock--but especially for high-valuation growth stocks--triggers a violent comeuppance.
Faltering for a year or longer will send you to growth purgatory--and from there, a company rarely finds its way back. Think of Polaroid, Xerox (nyse: XRX - news - people ), Eastman Kodak (nyse: EK - news - people )--even Microsoft today, compared to five years ago.
Wall Street harbors some misgivings about Google's management. There are overtones of arrogance about how they scaled up headcount, which impacts operating margins. Near term, Google's acquisition has, so far, borne no fruit in attracting advertising on YouTube. The company is spending $300 million annually for the right to sell advertising on News Corp.'s (nyse: NWS - news - people ) MySpace--also with no results to date.
Presently, Google is bidding for cellular spectrum, a long-term project where the initial investment could run up to $5 billion with no chance of profitability in the near years. I am among many who assume their holding strategy is just to gain an open-access provision, not to actually win.
This is what growth companies do with their capital if they don't want to dividend it out or buy back stock. The $3 billion deal pending for DoubleClick gets them into display advertising, an important complement to Google's search advertising business.
Having said all this, Google at $500 sells at 24 times earnings, 16 times EBITDA and 33 times free cash flow. On its enterprise value to EBITDA and its price-to-earnings ratio, Google is now a reasonably priced property. Analyst-jockeys on the stock had attached $850 as a price target. I'm at $600 by year's end--if the recession is short. Google's status is now a "show me" stock.
Growth stocks shine when they exceed Wall Street expectations, but this is difficult in an economic slowdown. Google's investment spending is already shadowing operating profit margins, but management is unlikely to back off. The prize is too enticing: the lion's share of all advertising on Internet sites, and then in cellular telephony.
When Google went public a couple of years ago, Internet advertising held a 2% market share. Now we're up to 8% and counting. Saturation is nowhere in sight. Why can't the Internet take a 50% share or more? I'm sure Google and Microsoft believe that's where it's going. Nobody knows whether all the social networks gather serious advertising dollars, but the players can't risk missing the opportunity. The world's Internet advertising market is $42 billion, and likely to double in three years.
I'm not turning my back on this property, but any upside surprises could be a year away.
Meanwhile, Microsoft is spending the equivalent of 15% of its market capitalization to buy Yahoo!. It's trying valiantly not to slip into middle age and look like IBM (nyse: IBM - news - people ). Give 'em credit for trying, but Microsoft's offense against Yahoo! is a long-run, defensive move to protect its desktop software franchise.
I own Microsoft because it's a cheap stock. With Google, you can still model a 30% growth rate for several more years--but if they keep spending money like drunken sailors and come up dry, the market will punish them.
Martin T. Sosnoff is chairman and founder of Atalanta/Sosnoff Capital, a private-investment management company with over $8 billion in assets under management. Sosnoff has published two books about his experiences on Wall Street, Humble on Wall Street and Silent Investor, Silent Loser. He was a columnist for many years at Forbes magazine and for three years at the New York Post. Martin Sosnoff owns personally, and Atalanta/Sosnoff Capital owns for clients, the following stocks cited in this commentary: Google, Microsoft, and IBM.
