Why Microsoft will end up buying Valve (and Valve will end up running Microsoft), why Gabe Newell will be the new Steve Jobs and why we’ll all be happy that ding-dong Steve Ballmer is gone.

Four months ago, I made a prediction on Founderware that Valve was going to be acquired by Microsoft. Since pretty much not a single person agreed with my opinion, and every time I mention it people pull weird faces, I decided to explain in detail why I am convinced it will definitely happen.

My belief is that Valve has been on course to be acquired by Microsoft for several years. Here are some facts.

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A few things about Valve:

Valve was founded by former Microsoft employees and, unlike many tech titans, is not located in Silicon Valley but less than 10 miles from Microsoft HQ.

Gabe Newell (Valve’s CEO, founder and, if I’m not wrong, its only shareholder) keeps giving interviews where he states that “he doesn’t want to sell“. Many take him at face value. Well. Firstly, in M&A, when you don’t want to sell you just don’t. There’s no need to blab to the press about it. Secondly, if your statements appear in the press, it usually means that what you are saying is: “I am not for sale. Unless you offer more than X. Then we’d totally sell out.” I believe this is the message Mr. Newell is trying to convey.

According to the New York Times, EA has been in talks to acquire Valve several times and each time they were rejected on valuation grounds. The gist of it is that EA offered less than $1 billion, but Valve wanted more than $2.5 billion.

Valve owns Steam, which is the second largest app store after the iTunes Store. It controls 70% of the digital download market for PC video games (which in real terms means that it’s making $2-3 billion in revenues at 30% gross margin). Steam has 54 million users with 6.6 million concurrent users logged in.

Steam has VoIP, IM, social features, achievements and a mini-Kickstarter built in, called Greenlight, for its own games. It supports F2P titles with in-app purchases, flash sales, pre-sales, promotions and has a great collection of indie games. Oh, and it’s also expanding on OS X and Linux.

In other words, Steam recaptures all the value it creates without leaking energy.

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In the case of some games, Steam by itself was responsible for 80% of revenues. And we are talking AAA mainstream games like The Witcher 2, not some Bumfuck Willy: The Fedora of Time 2D type of indie nonsense.

In Q3 2012, Steam added, for no apparent reason, non-gaming software to its library. This move is exclusively designed to render the underlying OS ‘just a bunch of drivers’ and make it irrelevant.

Valve is reportedly working on a Steam Linux box. This can only be intended to remove the Windows license and its concomitant restrictions from the market. Then, a few weeks ago, some of the designers on the hardware team were laid off. (A sign that Microsoft is already in talks to acquire Valve and they were getting their house in order?)

Valve owns one of the few independent app stores out there and the others are tiny in comparison. (I am nonetheless expecting GOG and Green Man Gaming to be acquired, leaving only branded app stores out there. Disclaimer, some of the investors in my company are also investors in GMG.).

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A few things about Microsoft:

Looking at the micro level, it seems that Microsoft is just full of nasty backstabbing middle managers who violently defend the P&L of their unit, as opposed as working as a group (non-backstabbers get fired thanks to Microsoft’s bone-headed employee review method called ‘stack ranking’. it’s terrible and everyone points at it as the reason why Microsoft lost ground against its competitors.)

At the macro level, everything changes. Microsoft is extremely simple to understand as a company: it has to sell a $52 Windows license to every new PC (net price; not what the user pays). Plus it needs to collect about another $67 of Office revenues. Everything else in the company is non-core, and effectively an accessory to enable or defend these actions. Look at the chart below (courtesy of Asymco): Microsoft makes a lot of revenues in many areas, but profits? Well, just in two places. Everything else is irrelevant.

Microsoft is facing also a crisis because the forever expanding PC market has, well… stopped expanding. -1%, in fact, in the past few years, while the tablet (read: iPad) space grew like crazy:

This is one of the reasons Microsoft was forced to create the Surface. Asymco has a nice dissection about that. It boils down to the company making about $120 profit per device.

But they need to find a way to sell millions of these things, and so far they are failing spectacularly (Microsoft hoped for 3 million units and managed to move less than 1 million), mostly thanks to a confusing product line.

I am an early adopter with several tablets and I can’t for the life of me describe their Surface product line; it’s just schizo. Superbad.

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Since their tablet strategy failed (pray let us not even mention mobile phones), Microsoft need to control the economics of software distribution on the PC platform in order to stay in business.

But today Microsoft does not control software distribution, and this means that not only are they are missing out on additional revenues but core profitability is in question in the long term in a world of $1.99 apps (remember, selling the OS is not enough; you need to be sold an expensive copy of Office as well or the whole house comes crashing down). And $MSFT has been a stock that despite its ups and downs has delivered profits by the truckload, thanks to Office, over the years.

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It is important to point out that Microsoft, with Windows 8, did indeed try to control software distribution by bringing in its own app store, insipidly called ‘Windows Store’ – not to be confused with ‘Microsoft Store’, which describes their equally insipid retail outlets. (Seriously: who the fuck is in charge of design at this company?)

Surprise, surprise, who went to the press to complain? Step forward Gabe Newell. He called it “a catastrophe” that will make users “rage quit computing” and then few months later called it “this giant sadness“. Others echoed the sentiment on social media, but he was the one that went to the press first.

Mr. Newell’s comments were taken at face value. His ownership of Steam, Windows Store’s biggest competitor, was often glossed over or went entirely unmentioned.

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Overall sales of Windows 8 are so bad that in fact it will be thrown under the bus this October by Microsoft in favor of ‘Windows Blue’, making it the shortest upgrade cycle in Microsoft’s history. The alternative would have been to throw Ballmer under the bus, but he still has the backing of Bill Gates.

But the new OS will still be a failure. Microsoft is crippled by its Windows/Office mentality. So a new strategy and new management will be needed.

iTunes has shown that a software distribution platform can be an enormous success and not just a feature: over time, it can overtake OS sales (and in the case of OS X, it has):

So, based on all this, here’s my theory:

Gabe is not against selling Valve but being already in the ‘top 1,000 richest people on the planet’ club it’s not that he gives too much of a fuck about money anyway. He needs to fill the wallet and the ego at the same time to make it worthwhile.

Microsoft, by integrating Steam into Windows, would go from having an anaemic and hated app store to having the 2nd largest store by revenue after iTunes, and more importantly the biggest one with social features. It could rip apart the communications component of Steam and replace it with Skype. The purchase would keep core gamers firmly entrenched on the Windows platform at a time when innovation is mostly happening on iOS. The new Playstation 4 is a PC without Windows. But the new Xbox could be a Steam Box.

The more one considers this integration, the more it makes sense. It would even give Microsoft control over software distribution revenues on non-Windows platforms like Linux and OS X.

Steam has DRM. And Microsoft loves DRM. No, Microsoft *fucking adores* DRM.

Any acquisition would see Valve being subsumed and Gabe running a sizable chunk of Microsoft – at least ‘Entertainment and Devices’, if not all of it.

Remember when when Gil Amelio bought NeXT and brought Steve Jobs back to Apple. He thought it was to appease the fanbois and in few months he ended up being fired by a board coup orchestrated by Jobs himself (who used his own money to anonymously short then sold anonymously all his Apple shares to depress the price further and gather support as an extra classy touch). This could be very similar and fits the narrative of a world starved by the premature loss of Jobs.

The news world demands a new tech messiah.

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I am going out on a limb and say that Gabe is aiming at being the next CEO of Microsoft.

Why? Well, he was one of the ‘Microsoft millionaires’ i.e. the early employees that got rich with share options before leaving and founding Valve. Like Gates, he is a Harvard drop-out. He built both companies and he is close to them in geographical terms. And, as I said a moment ago, the current toxic company culture is what is keeping Microsoft behind. (Strange, isn’t it, that Valve keeps pushing articles in the Wall Street Journal about HOW AWESOME THEIR COMPANY CULTURE IS AND THAT THERE IS NO MIDDLE MANAGEMENT WOOHOO FREE BAGELS AND COFFEE FOR EVERYONE). Did anyone ever question why, suddenly, all these articles about company culture are appearing? My guess is that they were designed to influence the rank and file at Microsoft and its shareholders where the company culture is perceived as the business’s greatest problem.

Check this ‘Welcome to the Bossless Company’ as an example.

What better ego trip than going from being CEO of one of the best video games companies to CEO of one of the best software companies in the world? With the added, lip-smacking pleasure that comes with running your former employer.

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Yes, Gabe likes making games and selling silly virtual hats and guns that make big dimensional holes. And, speaking from personal experience, the game industry really is a lot of fun. But running Microsoft? It’s a once in a lifetime opportunity.

All the moves and noises that Valve is making at a strategic level are designed to force the hand of Microsoft by disrupting their business model so it cannot be ignored forever. This cannot happen without Gabe’s approval.

Microsoft’s share price has lost -49.46% (vs. the entire NASDAQ being down -18.48%) since Ballmer became CEO in January 2000:

(If you want to compare it to Apple’s share price you need a log scale)

Steve Ballmer has been able to keep his job because he eliminated the competition (remember Sinofsky anyone?) and because Microsoft delivered on profits (and on some incredible investments: it put $150m in Apple in 1997 and $240m in Facebook at a $15bn valuation). But this is about to change with the next iteration of Windows. Consumers won’t upgrade to Windows Blue, and in a world of $1.99 apps, nobody will buy a 15-year old word processor + Excel for $220.

Who else has the money to pull it off or to compete against Microsoft for Valve? I am inclined to strike out Google since their focus is to keep Google+ relevant (uh, good one) and they seem determined to capture the advertising spend for that ‘80% of the household budget’ that mothers control (detergents, food, and so on: all that ad money is still spent offline). So a product for dedicated core users, mostly young males, does not fit. Apple is also out, since they do not care about games.

The other company to keep your eye on is Tencent, whose stock has actually outperformed Apple over the past five years. They dominate the social and gaming spaces in China and Valve would give them access to the US market. I’m sure the anti-competition commission would throw a fit over this one, but even if a bid from them does not end well, it would surely jack up the price.

EA does not have the money and might be taken private at $20 a share when the new CEO gets in anyway. Amazon is also a possible candidate, and local as well, but there is space for only Bezos or Newell in that company, not both.

(Tencent’s [0700] growth is surely impressive, it is now the 3rd largest Internet company in the world after Amazon and Google)

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So I am expecting Valve to be bought by Microsoft very soon, possibly this year during the new Xbox announcement or the first reporting quarter of the next OS, for a price of about $4.5 billion cash upfront and up to $3 billion in long term incentives. (Microsoft had $66bn in cash and short term investments as of September 2012.) I further expect Gabe to be promoted to CEO once Ballmer is pushed. Because, let’s face it, that’s one man who is never, ever going to quit.

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PS. Thanks to Dylan Collins and Mylo Yiannopoulos for the suggestions while writing this post. All non-NASDAQ charts are © of Asymco, which is pretty much the best blog on mobile technology and that you should read religiously.