Microsoft Becomes Just Another Company

By James Kwak

Last week, Microsoft (MSFT) issued long-term debt for the first time in its history, selling $3.75 billion of 5-, 10-, and 30-year bonds.

From a corporate finance perspective, I guess this makes sense, since it got to lock in historically low borrowing rates. Treasuries are low, and Microsoft paid only about one percentage point more than the U.S. government, which makes sense since it does have over $20 billion in cash, no other long-term debt, and – let’s not forget – a virtual monopoly on computer operating systems and basic desktop software. (In some ways, Microsoft looks like a safer place to lend money than the U.S. Treasury, except for the ability of the latter to print its own money.)

But it’s still a little sad.

First, we have an (optional) Corporate Finance for Beginners interlude:

There has been a ton of research on the optimal “capital structure” for companies, meaning the ratio of debt to equity. Conceptually, companies raise money from two sources: debt (selling bonds) and equity (selling common shares). Debt, as we know, has to be paid back; equity doesn’t. In the 1950s, Franco Modigliani and Merton Miller proved that, under certain (quite large) assumptions, the capital structure of a firm doesn’t matter. In the real world, however, there are a number of reasons why it should.

The simplest question is probably why any company would borrow money that it doesn’t need. After all, Microsoft has over $20 billion in cash, and it continues to make money. Taking on unnecessary debt isn’t something that I would do in my personal finances. But the idea is that companies are different: all of their money comes from and eventually belongs to someone else – for convenience, let’s call them bondholders and shareholders – so it’s just a question of which source is better. For one thing, a company could simply raise money by selling bonds, and then turn around and give the money to its shareholders. So from one perspective, you should ask the shareholders if they would rather have more cash in their pockets, or own a company that had less debt and was therefore worth more.

One major consideration is taxes. (The simple form of the M&M theorem assumes no taxes.) The interest on bonds is tax-deductible for the company, while dividend payments to shareholders are not; they are paid out of after-tax income. So in that sense debt financing is cheaper than equity financing.

But the broader issue has to do with the cost of capital. The cost of debt is pretty simple – it’s the interest rate you have to pay on the bonds. But the conceptual point is that equity has a cost as well – it’s the rate of return that shareholders expect to get by buying common stock. The higher that required rate of return, the less they will pay for your shares, and the more expensive it is to raise money by selling shares (because you need to sell more shares to get the same cash in return). Even if you (like Microsoft) have enough cash on hand that don’t need to sell shares, you could be using your cash to buy back shares on the market; by not doing so, you are implicitly “selling shares” and paying the cost of equity. That’s the concept, at least; trying to estimate your own cost of capital can be very difficult, and trying to estimate the cost of capital for a marginal transaction is pretty close to impossible.

Now, back to Redmond.

A company like Microsoft – with no debt, lots of cash, and a highly profitable business – has an extremely low cost of debt. If Microsoft took on a huge amount of debt, that cost of debt would go up, because investors would see that debt as riskier; the more debt you have, the higher the risk that you will default. But given where they are on the curve, the textbook answer is that they could afford to take on some debt.

But what is Microsoft going to do with that extra cash? There seem to be two main theories: (1) buy back more shares than it is already buying back and (2) buy companies.

I’ve never fully understood why some people think that buying back shares is always a good thing for shareholders. If your market value is $100, and you use up $10 in cash to buy back shares, then it’s true that there are 10% fewer shareholders that the value has to be divided between; but it’s also true that your company is worth exactly 10% less. In practice, share buybacks can boost share prices because they act as positive signals: if the company thinks its stock is underpriced, then maybe it is.

But I don’t see how it can work as the long-term strategy that some companies, like IBM, think it is.

As for buying companies, Microsoft already had enough cash to buy any company that could actually have benefited by being bought by Microsoft. Sure, Yahoo! (YHOO) and SAP are out there, but they’ve already done all the innovation they’re ever going to do; from this point these companies are just playing a game of adding their earnings together and trying to minimize the number of shares to divide them by.

In short, issuing debt looks like just the latest step on Microsoft’s way to being a company that uses financial engineering to boost its share price rather than inventing new products.

Now, I know that Microsoft has thousands of very smart and ambitious employees, so the fact that it has become a sinkhole where talent goes in and nothing new comes out is sad. The simplest explanation is probably that Microsoft is not too big to fail (although maybe it is – what would happen to our economy if nobody were around to fix security holes in Windows and IE??!!), but simply too big to manage. In addition, software has a tendency to get more and more unwieldy and difficult to modify as it gets bigger and older, and Windows is one of the biggest and oldest programs around.

So maybe it’s a smart move. But it isn’t anything for Bill Gates to be proud of.

Comments

[User 384162:]

Share buybacks actually have much more impact than the author describes. While it is true if the company has $100/share cash and it spends $10 on share buybacks it does reduce the cash by 10%, that doesn't mean the share price would be reduced by 10%. Share price is more than just the cash a company had, otherwise Microsoft would be worth less than $3/share!

Some of the positive impacts of a share buyback are:
* Reduced number of shares improves the earnings per share.
* Reduced number of shares reduces the costs of dividends to the company improving cash flow going forward.

The article is correct that computing the cost of using cash on hand can be extremely complex, depending on what is being done with that cash.

In general I'm very disappoint that Microsoft didn't buyback a ton of stock when it was trading in the mid-teens. However, Microsoft taking on this modest (for them) amount of debt is a non-event.

May 17 11:00 AM

[John Lounsbury:]

There's an old saying: "You can't teach an elephant to dance." (Actually, it has been done, but let's just ignore that fact.) A company can become very large and be manageable, but that is often done by managing it as a collection of individual businesses, which benefit from synergistic relationships where there is advantage and are stand alone otherwise, sometimes even competing with each other. GE and IBM are models of this type of organization.

And then there are companies like Microsoft that are vertically and horizontally integrated. They end up with two difficulties, one from within (momentum of a monster is difficult to redirect if it is headed toward trouble) and one from without (anti-monopoly regulation). The suggestion that James makes that maybe Microsoft will diversify into financial engineering is unsettling because that really does not address either of the two difficulties. And it is also unsettling because this is the very activity that may take years to recover from what has transpired over recent decades.

Microsoft should look at the IBM model. IBM transformed from a Microsoft-like monolith (hardware and software producer), which became to big to manage efficiently, into a partnership of hardware, software and service businesses. These businesses have interrelationships, but also enough independence to be managed individually.

James wrote: "..it has become a sinkhole where talent goes in and nothing new comes out.." Microsoft needs to develop some new businesses and they should not be finance businesses. Microsoft should use some of that talent in the sink hole to solve problems outside of the Windows superstructure. New lines of business will develop, and maybe even provide healthy competition for Windows based technology.

May 17 11:03 AM

[Ricard:]

Two comments on this article:

1) This is the beginning of the long road to GM hell for MSFT. GM, like MSFT, was once the predominant maker of its product...and look at it now. MSFT is currently suffering from the same malaise that GM has been suffering for years - no fresh product, entries into new markets unsuccessful, reputation for its core product being slowly chipped away. It doesn't have to be this way, but I don't see MSFT steering away from this path with its recent actions. It has already developed a strong reputation in other markets as an also-ran.

2) Regarding share buybacks, my understanding of the core logic is that share buybacks boost earnings per share of the shares remaining. All companies want to do is post EPS growth, and unlike other options (dividends, for example), share buybacks lead to a permanent rise in EPS, given that earnings stay the same.

May 17 11:13 AM

[Grahamite I...:]

It is a good thing the author noticed that fast that this is the first bond offering ever made by Microsoft, I had made an article about it on my blog.
I had also considered it using the M&M theorem II and clearly noticed the clear tax advantage for the company. But the reasons they implied for the use of the money simply dazzled me... mostly considering their $20 billion position.
I don't think we have to worry about Microsoft's future.

May 17 01:33 PM

[Roginfl:]

I echo Grahamite's thoughts. The advantages of Microsoft's bond issue (those obvious and well known -- and those not so obvious and yet to be announced) far outweigh the disadvantages. I too don't think we have to worry about Microsoft's future.

May 17 03:17 PM

[Josh B Thom...:]

The marketplace and a firms prospects are not as simple as your article pretends. Your article ends the same way most anti-microsoft articles end: with a disclaimer of all the comments: "So maybe it’s a smart move..."
As I was reading the article I thought, "I'll bet he is going to disclaim his comments in the last paragraph." And, You did!! Considering MSFT is making billions, it makes sense to disclaim any negativity.

May 17 09:15 PM

[jack dee:]

inflation, anyone....

May 17 09:29 PM

[DarkStealth:]

Microsoft will use this money to essentially play the currency market. With 60% of revenue from overseas, I believe the company wants to keep more cash in local markets around the world, or at least not in the US dollar. (Maybe this is a tax dodge instead of a hedge against the US dollar - I'm not sure.) But most of their costs are in US dollars - they just wanted access to really cheap dollars to give them more flexibility.

Also, they are very likely to be buying back MSFT stock.

May 18 06:06 AM

[johngonole:]

Stock buybacks are great if the company trades around book value because they not only boost earnings per share but they don't hurt the balance sheet. But when a company trades at 2x or worse 5x book value then share buybacks quickly decimate the balance sheet because they are paying for future earnings just like the rest of us that are not a for sure thing.

I never thought about the dividends issue mentioned in the one of the first posts. From a cash flow standpoint that makes a lot of sense. On the otherhand they don't have to pay a dividend.

The major problem I have with microsoft is that they don't seem to know how to deploy their cash and innovation is sure lacking for a company with their size and power. I suspect they won't know what to do with the bond offering proceeds either.

Microsoft should branch out into energy production or something like that if they are going to continue to piss thier resources into innovation oblivion. Its amazing how fast google innovates compared to microsoft.

This from a microsoft shareholder who only holds shares because of valuation.

May 19 01:43 AM