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Updated daily. All values annualized from Jan. 2008.

An exciting thing happened a few weeks ago. Pulling up the large cap screen on www.magicformulainvesting.com, there in the top 50 was Microsoft, one of the best known and ubiquitous companies in the world. Since it appeared, it has moved up into the top 25 over 2B.

Under normal circumstances, MagicDiligence would not hesitate to rubber stamp Microsoft as an instant Top Buy. The company is enormously profitable (generating over 2000% return on tangible capital), a financial citadel (21 billion in cash, no debt), a gushing cash cow (30% FCF margin), managed for shareholders (big share buybacks and a dividend), and has a near monopoly in operating systems and productivity software, giving the company huge competitive protection.

Of course, Microsoft's cheap 8.6% EBIT/EV is due to one thing - it's unsolicited 44.6 billion dollar bid to acquire Yahoo! MagicDiligence sees this acquisition having the potential for huge value destruction, and little potential for meaningful value creation. To understand this position, we merely have to look back at some successful and unsuccessful mega mergers to see what works and what doesn't. The following 3 criteria have been generally useful in determining a successful merger from an unsuccessful one.

1) Acquired assets should complement, not replace, current assets.

Successful mega mergers like Exxon + Mobil, and Proctor & Gamble + Gillette, worked because the acquired assets nicely complemented existing ones instead of replacing them. Exxon acquired Mobil's oil extraction properties, refineries, equipment, and service stations in areas where Exxon did not already have a presence. P&G acquired brands and products in market segments where they were not well established. Additionally, existing infrastructure like marketing and administrative was easily applicable to the acquired business.

Yahoo's primary businesses already have an analog in today's Microsoft. Yahoo Search competes with Live (MSN) Search. Yahoo Finance is a direct competitor of MSN Money. Yahoo Mail vs. Hotmail. The list goes on.

So what will Microsoft do? Killing parts of Yahoo! is throwing away purchased assets. Killing some of their own online initiatives is a huge amount of investment wasted. Either way, shareholder value is destroyed. That lost money could have been returned in the form of share buybacks or dividend payments.

2) Corporate culture has to be reasonably compatible.

This is most evident in failed mergers. Daimler and Chrysler is a prime example. Daimler's corporate culture and focus was up market, brand focused, high margin automobiles. Chrysler had been a core market producer who focused on volume and cost. To add to the problems, you have the inevitable clash of language, distance, and culture, as well as a totally different employment environment in the US. The combined company never shared technology. It was two separate companies masquerading as one, and Chrysler continued to underperform.

Yahoo! and Microsoft obviously are not compatible in a corporate culture sense. Yahoo! is a Silicon Valley company, where the prevailing drivers are entrepreneurship, technical savvy, and sharing of ideas. Microsoft is corporate to the bone, and prefers to make everything it does proprietary. Making things worse is that nobody in Yahoo! wants to work with Microsoft (witness the "anyone but Microsoft" vibe from the board of directors). This will make it very challenging to realize any "synergies" that may exist.

What's more, the two companies are technologically incompatible. Yahoo! relies on open source technology stacks (such as Apache, PHP, Linux), while Microsoft uses it's own technology (SQL Server, Active Server Pages, Windows). It's unlikely Microsoft would even hire a Yahoo! engineer with irrelevant skill sets. And now they want to hire ALL of them?!

3) Acquisition experience is extremely important.

Acquisitions, especially large ones, require a tremendous amount of time, effort, and planning in order to add value to shareholders. Sure, Microsoft could run Yahoo! as a subsidiary and add it's 660m of net profit to the bottom line. But it would take 66 years at that rate to give back the 44 billion to the shareholders! That's unacceptable. The merger has to provide return on invested capital at a rate close to or exceeding Microsoft's current lofty standards.

Microsoft has very little experience in executing acquisitions, and no experience pulling off mega mergers. Companies like P&G, Oracle, and the large banks have experience and knowledge in how to pull these off. It's part of their strategy. Microsoft's strategy has always been to develop from within. From software to internet to mobile platforms to gaming, the company is proprietary to the core. Can we assume they will successfully excel in an area they have no experience or knowledge of? Perhaps they will, but the evidence is clearly against a successful outcome.

For these reasons, MagicDiligence can't green light a Magic Formula stock that is also one of the world's best companies.

Steve owns no position in any stocks discussed in this article.

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