Microsoft's Substantial Upside Potential Using Foreign Cash

Oct.23.13 | About: Microsoft Corporation (MSFT)

A recent look at Microsoft's dividend prompted Seeking Alpha reader ALiveH to wonder aloud about Microsoft's (NASDAQ:MSFT) offshore cash and how the company would access it. Thus, in this article, we'll take a look at Microsoft's foreign cash hoard, a couple of ways the company could access it and the consequences for shareholders of those actions. As a note, all figures are from MSFT's most recent 10-K.

To start, MSFT, like many tech companies including Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOG), funnels most of its business, regardless of where it takes place, through operating subsidiaries in foreign countries with very favorable tax rates. This is perfectly legal and MSFT is well within its rights to do so. The consequence of this, among other things, is that when MSFT generates cash from its business, most of it ends up in these foreign operating subsidiaries. In fact, at the end of fiscal 2013, MSFT reported $77 billion in cash and equivalents but a whopping $69.6 billion of that cash was tied up in foreign subsidiaries. That means that MSFT's U.S. operations have only 10% of the company's cash available.

So now that we know the vast majority of MSFT's cash is tied up in foreign subsidiaries, how will the company get to it? There are a couple of ways the company could take advantage of the massive cash hoard abroad for U.S. uses. First, the company could simply repatriate the cash at will. This would, of course, trigger some nasty tax consequences as the U.S. has an arcane tax rule that levies taxes on foreign earnings once they are repatriated to the US. MSFT's total effective tax rate last year was just under 20% but that includes the majority of its earnings taking place in foreign jurisdictions with lower tax rates. So if MSFT were to repatriate all of its cash, just for the sake of this exercise, I'll assume it would pay 30% on its repatriated funds. MSFT would receive U.S. tax credits for any taxes paid to foreign jurisdictions so the repatriation rate would be lower than the headline corporate tax rate. Thirty percent should be sufficiently high to mimic reality, should this happen.

So we know that MSFT has $70 billion in cash parked in its foreign subsidiaries and we are assuming a 30% repatriation tax rate; this means that if MSFT were to repatriate the whole of its cash reserves at once, it would be subject to a tax bill of roughly $21 billion. Obviously, this is highly undesirable and I have to assume shareholders would not be amused if this were to happen. The reason this has not happened is likely for that very reason; an enormous tax bill such as that would be very unpopular as there are better ways to take advantage of foreign cash.

Speaking of better ways to access foreign cash, the more economically viable option is for MSFT to borrow against its foreign cash pile. There are a couple of ways to do this but basically, MSFT would take out a loan via one of its operating subsidiaries in a foreign jurisdiction and then funnel the loan proceeds back to MSFT's U.S. operations. The end result of this transaction is that the foreign subsidiary borrows against cash, reducing its book value, and then sends the loan proceeds to MSFT's U.S. operations, offsetting the decrease in book value of the foreign subsidiary. In essence, it is as though the U.S. operations took the loan but it is legally residing in the foreign subsidiary. This way, MSFT is only on the hook for the interest expense on the loan, which is also tax deductible.

MSFT has many debt issues outstanding currently, most of them relatively small in light of MSFT's size and reach, but they aggregate to about $15.7 billion currently. The weighted average effective interest rate on these debts last year was 3.06% so MSFT, as you would expect, is borrowing very, very cheaply when it decides to access the capital markets. Thus, if we assume that MSFT's foreign subsidiaries can finance debt at 3% for medium to long term bonds, the U.S. parent could gain access to large piles of cash for very little interest expense.

Using our example of the entirety of the foreign cash pile being repatriated at once, just for simplicity's sake, if MSFT were to issue $70 billion in debt at 3% through its foreign subsidiaries and then funnel the loan proceeds to the U.S. parent, it would be able to access the whole of its cash and equivalents for interest expense of about $2 billion per year. Contrast that with the $21 billion theoretical tax bill for simply repatriating the cash and you can see this is easily the more shareholder friendly option. In addition to that, the interest expense is tax deductible so the after-tax cost is even lower for MSFT with this option.

MSFT spent $7.5 billion on dividends last year and $5.4 billion in share repurchases for a total of almost $13 billion in capital returns to shareholders. According to what I found in the 10-K, MSFT's U.S. operations likely don't produce this much cash on their own so that would suggest that MSFT is already borrowing from its foreign subsidiaries in order to make these returns or it is using U.S. cash faster than it is generating it. Either way, the long term implications of MSFT's ability to borrow so cheaply in order to return cash to shareholders or make large acquisitions is positive for the stock. MSFT is no stranger to large acquisitions including Skype, Yammer and Nokia's device business and the best way for MSFT to continue to create long term shareholder value is through its foreign cash reserves. As long as MSFT can earn more than the after-tax cost of its foreign debt, less than 3% by my count, these acquisitions are likely to continue. In addition, MSFT could use the proceeds of foreign debt to pay special dividends, increase the regular dividend, finance additional share buybacks and much more.

MSFT has done well to generate enormous sums of cash in the course of its business but unfortunately for shareholders, most of that cash is outside the U.S. and subject to enormous repatriation taxes. As repatriating cash outright is unlikely due to the enormity of the tax bill that would ensue, MSFT could instead borrow against its foreign cash hoard and funnel the loan proceeds to the U.S. for general use. The implications of this for shareholders are many. MSFT could fund another special dividend, such as the $3 per share cash dividend that was paid in 2004, and another could be another very real possibility. In addition, the company is a serial buyback candidate so it wouldn't surprise me to see MSFT borrow against its foreign cash pile in order to finance buybacks.

The interesting thing about borrowing to finance buybacks is that I pegged MSFT's after-tax cost of debt at perhaps 2.5% or so, depending on the eventual tax rate paid, and MSFT's current common stock dividend is 3.2%. Thus, shareholders should not only encourage that MSFT borrow from its subsidiaries but demand it. This would be a cash flow positive event as MSFT would use cash it already has on hand and actually save money each year by using it to repurchase shares that are yielding more than the cost to retire them. And this doesn't even include the possibility of shares simply becoming more valuable over time.

The point is that MSFT is in a terrific position for long term shareholders to accrue benefits from its significant cash pile. There are many ways for the company to take advantage and I think we will see an announcement, perhaps from the eventual new CEO next year, of ways the company plans to use its cash. Any of the uses I described, apart from outright repatriation, will be positive news for the stock. A huge buyback is the best option in my view but even if a special dividend is paid or the regular dividend is increased, shares will move up in response to the move.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.