Microsoft Debt Deal A Necessary One

| About: Microsoft Corporation (MSFT)

There are times when you can clearly see things coming. Companies can be predictable at times, and Microsoft (NASDAQ:MSFT) is a good example currently. After the bell on Tuesday, the technology giant announced a large debt offering. While this news may have surprised some, I was one who has stated this move would be coming for a few months now. Today, I'll examine the debt news and explain why Microsoft needed to make this move.

Debt offering details:

The offering consisted of the following tranches:

  • €1.75 billion of 2.125 percent notes due Dec. 6, 2021
  • €1.75 billion of 3.125 percent notes due Dec. 6, 2028
  • $1.25 billion of 1.625 percent notes due Dec. 6, 2018
  • $1.50 billion of 3.625 percent notes due Dec. 15, 2023
  • $500 million of 4.875 percent notes due Dec. 15, 2043

The deal is scheduled to close on December 6th. As most companies do, Microsoft stated that the funds would be used for "general corporate purposes, which may include, among other things, funding for working capital, capital expenditures, repurchases of capital stock, acquisitions and repayment of existing debt".

Microsoft needed cash?

I first brought this up in my fiscal first quarter earnings article for Microsoft. You would normally think that Microsoft, a global technology giant, would be in great financial shape. Well, that is true, but the devil is in the details. As I pointed out in the article (and table below), Microsoft's huge cash position wasn't what it seemed. Dollar values below are in millions.

*Liabilities to assets ratio.

The key number is the US held cash and short term investments balance. As you can see, it was under $4.7 billion at the end of September (fiscal Q1). Almost all of Microsoft's cash and investment pile was located outside the US. That is important because Microsoft can only use domestic cash for dividends and buybacks. To use the foreign cash, the company can do one of two things. First, it can repatriate the funds to the US, which will entail a serious tax bill. The second way to "use" the funds is to borrow against them. Well, Microsoft basically did just that here.

What to do with the debt?

I expanded on this a bit more in my latest Microsoft article, as it was one of a few delicate items I said that the company needed to focus on. As Microsoft detailed on page 24 of its latest 10-Q filing, the company's $0.28 quarterly dividend payment will be paid on December 12th. The company states that the total dividend payment will be $2.337 billion. That figure is roughly equal to half of the company's US cash position at the end of the latest quarter.

Obviously, the company will have produced cash (including in the US) up to now. But the company also has an active buyback program in place, one that bought back $1.5 billion in stock during fiscal Q1. The company also announced a new $40 billion buyback plan a few months ago. If Microsoft wants to buy back more stock, it needs money to do it. The company also does not want to drain its cash pile, as it needs a margin of safety, plus funds to run the business. So taking out $3.25 billion in US debt will help to pay both the dividend and buy back shares.

Taking out debt to help with a buyback program is not uncommon for a large company like Microsoft. In just the past couple of years, Intel (NASDAQ:INTC) and Apple (NASDAQ:AAPL) have both taken out debt to help with their buyback programs. Apple took out $17 billion earlier this year to help it accelerate part of the program, something that helped Apple get its share count down rather quickly. Microsoft did not take out a large sum of money here, so it is likely that the company will continue its buyback at the $1 billion or so quarterly pace we have seen recently. I don't think investors should overreact to this debt news and think the buyback is going to accelerate rapidly.

How this could help:

As most investors know, there are a couple benefits to a buyback program. First, a company that is buying its stock back can be providing a signal that it believes its stock is undervalued. Second, it is a way to return capital to shareholders. A buyback also helps to reduce the share count (or lessen the rise of the share count), which can help earnings per share. Also, cash flow can improve as the share count is reduced, which lowers the total dividend payment at the same dividend rate.

Microsoft could use a boost to earnings per share, and the company does need to get its share count down. In fiscal Q1 compared to the prior year period, the diluted share count (used for earnings per share) was only down by 60 million to 8.434 billion. In terms of earnings per share, the reduced share count only improved earnings per share by less than half a penny. Due to rounding, it didn't even move the needle for the headline number. Microsoft analysts only expect the company to improve its earnings per share figure by 1 penny this year, so a stronger buyback would certainly help.

Where things stand now:

As I mentioned above, analysts don't see much earnings growth for Microsoft this fiscal year. How does Microsoft's overall growth picture stack up against some others in the space? Well, the following table shows some key comparisons in large cap tech land, and I've included Cisco Systems (NASDAQ:CSCO) and Google (NASDAQ:GOOG).

*EPS growth and P/E are non-GAAP.

In terms of expected revenue growth, Microsoft slides into third, just behind Apple. In terms of earnings per share growth, Microsoft is also in third place, but a really distant third. If Microsoft's average estimate were to come down by another penny, it would represent flat earnings per share, which would tie it with Intel at the moment. You'll also notice that Microsoft trades at the highest P/E value of the four dividend paying names. I still don't like Microsoft at a 10% plus premium to Apple, but investors are willing to pay that right now. That could change when the next CEO is announced, but we shall see.

Final thoughts:

Microsoft added a bit of debt on Tuesday. This was a necessary deal as the company's US cash position was a bit low, and a large dividend payment was upcoming. I don't think investors should read too much into this news, as it probably won't change the rate of the buyback, and the company already raised the dividend. This news reinforces Microsoft as a decent dividend play over the longer term, although I have stated I think this company is a short-term short play on valuation and the CEO news as discussed in past articles. This was an expected and necessary move for Microsoft, and while worth discussing, it is not one that investors should overreact to.

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.

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