You have a company that has an enviable, if slowly declining, franchise and a woeful record of executing large-scale acquisitions. What do you do if you want to maximise returns for investors?
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You might think you would run a tight ship, stick to the core business, and try to wring as much money from it as possible. What you wouldn’t obviously do is to find a struggling but stratospherically rated company in an almost unconnected area, then punt tens of billions of dollars on buying it without an evident way of earning returns on that cash.
In which case you are clearly not Satya Nadella, for this latter path is the one that Microsoft’s chief executive has just chosen. Last week, he launched the tech industry’s third-biggest acquisition ever, splashing out more than $26bn on LinkedIn, an unprofitable professional networking site whose income largely comes from recruitment.
It is a strange move for the world’s largest productivity software company. LinkedIn may have a huge network, with 430m registered users. But it is not clear how the business fits together with Microsoft; still less how Mr Nadella can use it to drive the group’s future growth.
True, there is some talk about using LinkedIn’s data scientists to take its new owner deeper into hot areas such as machine learning and artificial intelligence. LinkedIn’s own data cache might help Microsoft to build products that help customers manage customer relationships.
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But it is difficult to see many tangible benefits in terms of additional revenue. That matters when LinkedIn, for all its $3bn turnover, is still losing more than $150m a year.
So why has Mr Nadella elected to roll the dice on such an uncertain endeavour? It is hardly as if he is unaware of the risks involved in large acquisitions. After all, it was the failure of Microsoft’s $7.2bn purchase of Nokia’s smartphone business that persuaded the group’s shareholders to dump his predecessor, Steve Ballmer, giving Mr Nadella his shot at the top job.
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Nor can he fail to recognise the need to nurture Microsoft’s mature if still vastly profitable commercial software franchise, and how that remains the key to its fortunes. Just to give a sense of the unit’s importance, it is worth noting that in just the past two years its operating profit increased by $3.7bn — rather more than LinkedIn’s entire turnover in 2015.
But if Mr Nadella knows all this, there are also powerful temptations pulling him in the opposite direction. These are the lavish equity incentives that investors have heaped upon his plate.
Mr Nadella’s package means he might end up with a stake of between 1.3m and 4m shares over the next five years. What he ends up receiving depends partly on operating factors, but the biggest gearing effect comes if Microsoft’s shareholder returns exceed certain stock market-based targets linked to the S&P 500 index between 2016 and 2021. Hit the jackpot and he could walk away with stock worth more than $200m at the current market price.
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In principle, of course, these incentives do not stop Mr Nadella from maximising cash flows from the commercial software business. In practice, however, they strongly motivate him to find some short-term investment story that will encourage investors to put a very high price on Microsoft’s shares. That means diverting some of those cash flows into high-profile acquisitions such as LinkedIn, or investments in exciting but very uncertain ventures such as Microsoft’s “augmented reality” project, HoloLens.
Mr Nadella is not the only tech company boss to yield to this sort of temptation. Take Yahoo, for instance. Under Marissa Mayer, the internet group spent billions on acquisitions and innovations designed to put rockets under its share price. Yet Yahoo would have done better had it cut these costs back and maximised returns from a search engine business that may have been ex-growth but was still generating $4bn in revenues a year.
Investors need to think harder about the messages that incentive packages send to managers. In Microsoft’s case, these seem designed to encourage Mr Nadella to behave as if he’s running an Apple or a Facebook — tech companies that are at the forefront of consumer innovation. In fact, the business he is leading has more in common with HJ Heinz — the owner of a stable of familiar and highly cash-generative staple brands.
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Finding a way to match the incentive to the task is the next challenge facing investors in a fast maturing tech sector. That may mean getting more bosses to think like Warren Buffett, and rather fewer to approach the task in the manner of a latter-day Steve Jobs.
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