I have been reviewing the implications of ultra-low interest rates for the equity market and one of the conclusions that has become apparent is that financial engineering will become more and more attractive to corporations, and that this financial engineering will tend to support equity values. One important form that financial engineering can take is to share repurchase programs financed by borrowing at low interest rates. We have discussed Wal-Mart's (NYSE:WMT) activity and have shown how the repurchases can and do increase earnings per share and reduce the outlay for dividends.
Microsoft (NASDAQ:MSFT) is one of a number of companies criticized for maintaining a large cash hoard on its balance sheet. In recent months, MSFT has been accelerating its stock repurchase program and buying back ever larger quantities of its own shares. In the last six months, MSFT apparently spent a net $8.641 billion dollars on share repurchases and reduced its share count from 8.668 billion to 8.403 billion or by 265 million shares. In this time period, there have been roughly 128 days on which the market has been open and so the net share count reduction has proceeded at a rate of more than 2 million shares per trading day. In a six and a half hour trading day this works out to roughly 5,000 shares a minute or nearly 100 shares a second - read this fast or, before you finish, 25,000 shares will have evaporated.
I like to focus on total share count reduction because often the share reduction due to repurchases is offset in whole or in part by option awards. In the case of MSFT, the net share count has gone down significantly. Looking back at 2006, the share count has gone down from 10.062 billion four years ago to 8.403 billion at the end of the last fiscal year or by roughly 16 percent. MSFT is definitely engaged in a long term strategy of reducing its share count.
MSFT is such a powerful cash machine that, even after this activity, it had net balance sheet cash of roughly $41.6 billion on its quarterly last financial statement.
Using the EPEE methodology and backing out net cash and net interest income, MSFT, the operating company, (as opposed to MSFT, the money market fund) is trading at 8.3 times consensus 2011 earnings. More and more investors have been reaching the conclusion that MSFT is cheap at this price.
MSFT issued bonds this past year and was able to borrow at eye-popping low rates. I suspect they issued the bonds because savvy financial people in the company perceived a particularly favorable market and determined that it was simply too good an opportunity to pass up. The average pre-tax interest rate was less than 3% (there were a variety of maturities with higher interest rates for the longer maturities). Of course, interest is tax deductible and the after-tax interest rate was much less.
When your after tax earnings yield is roughly 12% and you can borrow at 3%, it is easy to see how you increase per share earnings by borrowing and repurchasing shares. In MSFT's case, with a dividend of 64 cents, there is a also a savings in reduced dividend payments whenever share count is reduced. The 265 million share count reduction will cut dividend outlays by roughly $170 million - probably more than MSFT would have earned after-tax on an amount of balance sheet cash equal to the share repurchase cost.
What does this mean for investors? I have always been a bit ambivalent about share repurchases and when I discuss the topic with friends I always get the feeling that they think that there is something "sneaky" about it or that it constitutes another example of Wall Street trickery. It definitely shows that MSFT thinks its shares are undervalued but it is also somewhat of a sign of a mature company in the sense that MSFT perceives share repurchases to be a superior strategy as compared with expenditures on expansion. On the other hand, Apple (NASDAQ:AAPL), which has been growing like wildfire, builds up a lot of balance sheet cash as well and does not seem to be able to find ways to spend it all cost effectively on expansion.
When MSFT buys back its own stock and reduces share count, every existing shareholder now holds a slightly larger percentage ownership interest in the company. In that regard, share repurchases have exactly the same effect as the issuance of a large dividend for those shareholders who participate in dividend reinvestment programs - after the dividend is reinvested, those shareholders have slightly higher percentage interests in the company. There is one very important difference - in the dividend reinvestment scenario, the shareholder is taxed on the dividend; in the share repurchase scenario, there is no tax consequence to the shareholder.
I like the idea of owning progressively larger percentages of MSFT without having to buy more shares - in the words of one investment guru, as the company buys back more and more of its shares, "you want to be the guy with the last share." Of course, that is not going to happen, even though MSFT is on a trajectory to buy back all of its shares in roughly 16 years, we all know that that isn't really going to happen. As the number of shares gets lower and lower, something nasty starts to happen - the price per share gets to be very, very high!
That is a very important reason that I am long MSFT.
Disclosure: I am long MSFT, AAPL, WMT.