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Earlier this week, Microsoft (NASDAQ:MSFT) announced a $40 billion stock buyback program, and raised its dividend 22%. These moves, coupled with the recent announcement that CEO Steve Ballmer plans to step down, and Microsoft's acquisition of Nokia's (NYSE:NOK) handset business, have placed an even larger than normal spotlight on Microsoft. In this article, I will focus on unpacking the significance of the share buyback and dividend increase, and try to see how this will affect Microsoft in both the short and long term.

Share Buyback

In order to determine the significance of Microsoft's share buyback we first need to assess the length of the recently announced program. Will the share buyback take one year? Five years? 10 years? 20 years? Clearly, the longer drawn out this buyback the less significant. Curiously, Microsoft did not put a fuse on this deal, leaving us to guess at the precise length of this buyback. If past programs indicate anything, then Microsoft's current program, like its previous buyback should last five years. Assuming this, Microsoft will spend an average of $8 billion per year on share buybacks reducing the share count (and thus increasing EPS) by 4% each year. Where will Microsoft get the money for this deal?

In its most recent filing with the SEC (p. 37), Microsoft reported cash of $77 billion, $69.6bn of which it holds off-shore. Microsoft spent 5.44bn euros ($7.26 billion) acquiring Nokia's handset business, which will reduce its offshore pile to $62 billion and its total cash to $70 billion. We need to ask, can Microsoft use any of this cash for share buybacks? In short, no -- to quote Zero Hedge

Using foreign cash to [for] ... share repurchases is considered repatriation from the perspective of U.S. tax regulations.

What about the bond market? Microsoft has taken advantage of record low interest rates by tapping the debt markets two times in the past year. It raised $2.23 billion in Q4 2012, and $1.13 billion in Q2 2013. This doesn't mean it cannot go back to the debt markets (especially considering it has a lower cost of capital than the Federal government!), but it does show the limits of its borrowing capacity. In order to fund $8 billion per year of share buybacks, Microsoft cannot look only at the debt markets, it will need to raise the cash from other sources.

Which brings me to the last candidate -- cash flow. Microsoft has generated $20 billion+ in operating income in each of the past five years, with the previous year clocking in at $26 billion. Microsoft then will need to spend close to $8 billion of this cash on share repurchases, which will increase EPS by 4%. While investors should find it disconcerting that Microsoft cannot find ways to earn more than 4% on its capital, at least it won't let it just sit in the bank earning less than 1%.

However, this whole discussion only covers one aspect of the recent news. Microsoft also bumped up its dividend 25%. In the next section I will closely analyze the significance of this move, and try to tie it all together with our previous discussion.

Dividend And Conclusions

Microsoft initiated its dividend program in 2003, and it has increased its dividend (albeit a bit choppily) over the past decade. The most recent dividend increase of 28 cents per share puts Microsoft's total cash payout to shareholders just under $10 billion. Using the same five-year time horizon as we did in the previous section, we can assume that Microsoft will generate somewhere around $25 billion in operating income in the next five years. The company will spend $8 billion per year on stock buybacks, and $10 billion on dividends, leaving it with approximately $7 billion of cash to work with to reinvest back into the business. At the current share prices, shareholders will see a 4% return in the form of buybacks, and a 3.36% return in the form of dividends -- a total of 7.36%. Considering the market grows on average of 7% per year, Microsoft then looks like a strong investment in the short term giving investors essentially a market rate return for holding onto the stock, and a free call on the appreciation. However, in the long term, this plan seems somewhat short sighted.

Microsoft dominates the PC market -- both in terms of operating systems and productivity apps. These two divisions generate the lion's share of Microsoft's operating income. Much has been made of the PC's decline in growth, and while the decline is real, the death is not. IDC projects flat PC growth for the next five years, even though the tablet and smartphone market will grow exponentially. It would seem for Microsoft to compete against the current industry titans -- Google (NASDAQ:GOOG) and Apple (NASDAQ:AAPL) -- it would want to keep that cash so it can invest in technology and marketing. Maybe it can accomplish that with $7 billion, but it would seem more logical to keep that cash as Microsoft continues to make an aggressive move into this brand new line of business.

Source: Unpacking Microsoft's Recent Moves