Microsoft s Acquisition of WebTV: Valuation and Real Options Analysis 1

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1 FIN 673 Professor Robert B.H. Hauswald Mergers and Acquisitions Kogod School of Business, AU Microsoft s Acquisition of WebTV: Valuation and Real Options Analysis 1 In May of 1997, Microsoft paid $425 million for WebTV Networks, a proprietary online service that provided internet access through a user s television set. At the time of the purchase, WebTV had 56,000 customers, translating into an acquisition cost per subscriber of roughly $7,600 (an enormous sum given the low potential adoption rate of this proprietary service). This purchase was roundly criticized in the media for the huge persubscriber price paid: earlier in the year, Mindspring (a consumer dial-up ISP) bought another ISP called Netcom, and its 350,000 subscribers, for $230 million or just $657 per subscriber. A DCF valuation of WebTV, even assuming phenomenal growth, indicates a negative NPV for the purchase. We will assume that WebTV would have 56,000 customers in 1997, and that this number would increase by 100% per year for years , then by 50% per year for years , then by 10% forever. Per-subscriber revenues were estimated at $200 for the WebTV hardware plus $25/month of service and an 18- month average subscription length. Operating margin was anticipated to be 11% (equal to AOL s margin), and the discount rate applied was 18.5% (average among ISP s). DCF Valuation of WebTV (All Figures In Thousands, Except Per-Customer Numbers) Cont. Value # of Customers # of New Customers Lifetime Rev. Per Customer $650 $650 $650 $650 $650 $650 $650 FCF Per Customer Total Free Cash Flow $4,004 $4,004 $8,008 $8,008 $12,012 $18,018 $27,027 $349,761 Total Value $148,058 Purchase Price $425,000 NPV of Purchase ($276,942) 1 Special thanks go to Richard Shockley for making this case study available.

2 How did Microsoft justify such a large valuation for WebTV a proprietary content provider with very few subscribers and a disappointing business performance? Our NPV analysis says that the investment has a negative NPV of over a quarter billion dollars and that is given a very rosy set of assumptions. To Microsoft, WebTV was much more than an ISP. Microsoft executives saw the purchase of WebTV as an opportunity to gain a foothold in the growing market for broadband digital television (DTV). Microsoft foresaw the coming integration of broadband digital communications and television, and realized that the television of the future would require an operating system just as personal computers do today. Microsoft realized that WebTV had created the industry s first low-cost computer device for a TV platform. WebTV, through its proprietary technology, offered a tiny building block to develop interactive content delivery to the home via the television. Some of the basic technologies WebTV developed for its boxes and network services were an ideal front-end for Windows CE (a scaled-down version of the Windows operating system for the PC) running on a TV platform. So the WebTV purchase was, to Microsoft, the first step in a strategy to eventually become the dominant provider of operating systems for the new hardware devices. Microsoft s objective was to own the component where the TV and the PC meet, and to eventually have every DTV embedded with WebTV and running Windows CE. Had Microsoft valued the broadband strategy using the traditional NPV rule, however, they never would have gone through with the WebTV purchase. Unlike the PC market, cable companies would have viable alternatives to WebTV for introduction of broadband service to the customer marketplace. Hence, Microsoft knew that it would have to purchase substantial minority stakes in the big four cable players (AT&T/TCI, Time Warner, Media One, and Comcast) who together control 54% of the U.S. cable market. This necessary investment was estimated to be about $7.9 billion. In addition, Microsoft would need to spend an additional $600 million on research and development. Together, these investments would give Microsoft the technology it needed as well as the 59% market share that management felt was necessary to take a dominant position in the market for broadband. The following DCF analysis assumes that Microsoft achieves the 59% market share by 2003 and that unit demand growth for broadband follows industry projections (with 10% perpetual growth after 2003), that the monthly service fee for broadband is $50 (based service fee in 1997), the operating margin is 25% of revenues, working capital requirements are 4% of revenues (based on Comcast WC structure), and the discount rate is 18.5%.

3 DCF Valuation of Microsoft's Broadband Initiative (All Figures In Thousands, Except Per-Customer Numbers) Cont. Value Forecast Unit Market Demand 3,000 5,300 6,700 8,100 9,400 10,800 MS WebTV Market Share 5% 8% 13% 22% 36% 59% MS WebTV Units ,782 3,384 6,372 $50/mo $90,000 $254,400 $522,600 $1,069,200 $2,030,400 $3,823,200 Operating 75% 67, , , ,900 1,522,800 2,867,400 Depreciation 12,500 12,500 12,500 12,500 12,500 12,500 EBIT 10,000 51, , , , ,300 35% 3,500 17,885 41,353 89, , ,155 NOPAT 6,500 33,215 76, , , ,145 Add Back Depreciation 12,500 12,500 12,500 12,500 12,500 12,500 Change in Working Capital (3,600) (6,576) (10,728) (21,864) (38,448) (71,712) Free Cash Flow 15,400 39,139 78, , , ,933 7,168,545 PV of Free Cash Flows $2,678,757 Capital Investment (8,500,000) NPV ($5,821,243) The static NPV tells us that the broadband strategy after the WebTV purchase is negative $5.8 billion. Why, then, did Microsoft proceed? Doesn t this tell us that the WebTV purchase is a bad idea? The answer is similar to the case of Conoco. The traditional DCF analysis assumes that Microsoft places a bet of $8.5 billion in 1997, commits to the broadband strategy, and rolls the dice. But this is not how Microsoft will proceed. Rather than committing $8.5 billion up front, Microsoft will commit around $600 million to research and development and wait a while to see if the market develops. If the market does develop (as anticipated), Microsoft will make the big purchase of stakes in the cable industry; if the market does not develop or develops more slowly than anticipated, Microsoft will abandon or shelve the project and just operate WebTV as a basic internet service provider. So Microsoft will act strategically. The company will be an intelligent gambler: Microsoft will wait for more information to arrive and then condition their investment decision on what is learned. That is, they will bet big when the odds are in their favor (and the expected benefits are large), and they will not bet at all when the expected benefits are small. In other words, Microsoft has an option on broadband service with a strike price of around $7.9 billion. The key issue here is that the purchase of WebTV is absolutely necessary to create this flexibility in the future. That is, if they purchase WebTV they are purchasing an option on the broadband service. The amount that Microsoft should be willing to pay for WebTV is thus the value of the option the purchase creates! Once we get through the technology, it is easy to show that the value of the option created by the WebTV purchase far exceeds the negative static NPV plus the cost of the required R&D. Purchasing WebTV doesn t simply purchase cash flows from an ISP or cash flows from a broadband service, but rather a more complex strategy of cash flows from and ISP and the option to turn that into cash flows from a broadband service if the broadband service s value exceeds its cost!

4 Today Future Market for Broadband Develops Buy Stakes In Cable Companies Payoff = Exp. PV of Monopoly - $7.9bil Buy WebTV and do R&D Broadband Market Does Not Develop Do Nothing Payoff = Value of ISP Provider

5 1. Exercise 1: Real Options Valuation On the basis of the data provided in this write up, set up a Black-Scholes-Merton real option valuation spreadsheet for Microsoft s acquisition of WebTV. The magical mystery parameter is, as always, the revenue volatility. 1. Set up the spreadsheet and extract all other relevant pricing parameters from the write up. You might need to go to public data sources for the risk-free rate. 2. Adjust the volatility until you find a real options value for the undeveloped technology that matches the missing value in the DCF cashflow analysis. 3. Download broadband stock data for the last six years from any number of public sources on the internet and, using Excel s volatility function, compute yearly stock price volatilities to see what kind of historic volatility we had in the last years as compared to the required volatility. 4. Construct a binomial lattice for the real options analysis. What is the crucial difference between the valuation and decision tree? 2. Exercise 2: MSFT - WebTV Valuation in December 2002 MSFT recently wrote down a large part of their portfolio of minority stakes to reflect its depressed value. What does this say about the real options in the WebTV case? Update the valuation exercise (both the DCF and real options parts) on the basis of current company data.