Two recent articles on the online ad industry – this one stating that online ad spending in 2007 will total about $21 billion and is predicted to double by 2011, and this one saying the only real barrier to growth in online advertising is the lack of accountability and return metrics – have gotten me to think that people are underestimating Microsoft (MSFT) on several levels. There seem to be many parallels between Wal-Mart (WMT) and Microsoft in that both are giants that far and away dominate their industries – and in many ways created their industries - yet they seem to get no respect next to faster growing and more intuitively attractive comparable companies like Target (TGT) and Google (GOOG).

One particular point of assailment has been Microsoft’s $6 billion acquisition of aQuantive, of which I have not seen one analysis praising the move in the six months since the deal was announced. So is everyone right, except for the guys with the money? My favorite description is that the deal was “good old-fashioned American bat-shit insanity.” Having ironically had a valuation of AQNT worked up (I was waiting for my brokerage deposit check to clear so I could buy the stock the very morning of the buyout announcement – if I could annualize 80% daily gains…), I’d say that Microsoft overpaid by just over 20%, or slightly more than $1 billion. At that time, Microsoft had more than $28 billion in cash and short-term investments on its balance sheet and, what’s this, $17 billion in free cash flow in the last year? People should at least applaud Microsoft for getting its money out of “enhanced” money market funds and into a very good complementary business.

Consider the following:
Revenues from Microsoft’s Online Services Business (OSB), which is primarily online advertising, were $2.5 billion in FY2007, or under 5% of total revenues of $51 billion.
Google’s consolidated revenues over the previous four quarters: $15 billion. Substantially all of that is from online advertising.

Obviously, Microsoft has much more to gain, and Google much more to lose, from Microsoft becoming a bigger player in online advertising. Even if you consider aQuantive to be a fly-by-night operation with a coin flip’s chance of success, think about it from Microsoft’s perspective – heads, we’re getting billions in marginal business, tails, we lost four months’ worth of cash.

Everyone likes to talk about the synergies involved in making a deal, especially when the deal is otherwise not financially prudent, and too often those are fluff. Simply looking at the valuation here shows that aQuantive wasn’t a bargain for Microsoft – so are those synergies for real? Unlike the treatment of aQuantive above for demonstrative purposes, the company was growing exceptionally fast pre-buyout and had revenues close to half a billion dollars. Yes, aQuantive had competitors, but the company offered a widely integrated base of services and was by all accounts doing very well. Tying in their specialty services in ad targeting with Microsoft’s MSN content network is going to give a huge amount of leverage to the deal; Quantcast estimates that msn.com has 50 million monthly uniques and its sub-domains collectively see tens of millions more visitors each month, so if aQuantive’s expertise can generate even a minor expansion in effective realized CPMs (rate per thousand impressions) then this deal could suddenly become much more accretive than most people seem to be accounting for. To throw some conservative numbers out there, if…

-The MSN network gets 75 million visits per month
-Each visitor looks at 120 pages per month (four per day)
-Then scale annual impressions served by 108 million = (75 million/1000) * (120 pages) * (12 months)

Now multiply whatever marginal eCPM benefit aQuantive can deliver to the MSN content network by 108 million, and you get some kind of mental model about the synergies and leverage in the transaction. Then you can start going in and considering aQuantive’s typical business, and how having access to all sorts of data on hundreds of millions of registered accounts on the MSN network will be able to help their advertising customers, and the deal suddenly doesn’t look so bad.

Am I being unrealistic in assuming aQuantive is going to help Microsoft greatly increase profits on its online ads? Perhaps. Send me an I-Banking job offer if I’m being particularly delusional. But don’t lose sight of the trend we’re seeing in online advertising: the people allocating the ad dollars desperately want to make an impression online - $20 billion today, $40 billion tomorrow – but they just don’t know how to properly apply their money. And that is the niche aQuantive will fill.

All the signs are saying online ads aren’t going anywhere, in fact, they are becoming more enmeshed in the internet all the time. News Corp.’s (NWS) purchase of Myspace.com for $580 million was over the top at first; and for the content it was buying the price was ridiculous. But the content wasn’t what News Corp. was buying; it was buying (to sound late ‘90s dot-com-ish) the eyeballs. And it looks like a great deal in light of Microsoft’s second idiotic purchase of late, a 2% stake in Facebook for $240 million, which values the site at $15 billion in total.

Like with aQuantive, the universal condemnation of this deal was apparent; Microsoft was being overly aggressive and simply trying to box Google out – think the Red Sox and their $50 million bid for Dice-K’s negotiating rights, when the next closest bid was the Yankees at $20 million – but I think there is one aspect of the Facebook deal that hasn’t been discussed, and that is (again) the synergies. Not necessarily anything to do with Microsoft, but what about with aQuantive? Taking a company that specializes in targeting ads to deliver high ROI and giving it access to all the data on Facebook (hastily checks pictures, removes one of doing shots) sounds like an interesting web 2.0/3.0/X situation. With about 60 million users, Microsoft is getting advertising access to everyone at $4 each, plus any upside from the investment stake. Still, you’re thinking this is just evidence that the Microsoft executive team is clueless, especially if you run Safari as your web browser. I don’t think that is necessarily the case though.
Why? Again, Microsoft can more than afford to invest that kind of money, because it makes $50 million per day in free cash flow. So to do an aQuantive-type coin flip scenario, Microsoft thinks ‘heads, we get to advertise to all these people at $4 each and get a piece of one of the fastest-growing, most explosive connectivity tools ever created’ or ‘tails, we basically worked this last Monday-Friday for free.’ I can almost see the Prozac delivery truck being diverted to Redmond.

Keep in mind, I’m fairly far over in the value camp – I like stocks like American Eagle (AEO) and USG – so for me to condone, much less praise, Microsoft’s investments here should hopefully say something. I wouldn’t personally make them, but I can certainly appreciate some degree of foresight in business, and that seems to be what Microsoft is showing. In my next post, I’ll explain more on the significance of the Facebook investment, how Microsoft is moving in on Google’s bread-and-butter, and why I think Microsoft’s moat is being underestimated, regardless of what you read daily to the contrary.

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Disclosure: I own USG, but nothing else mentioned here.