In our letter to Microsoft, we at Strategic Analysis Corporation say nay.
Mr. Reed Hastings
Lead Director, Microsoft Board of Directors
One Microsoft Way
Redmond, WA 98052-6399
To the Ladies and Gentlemen of the Board:
I have to respond to the letter from the hedge fund – only identified as X Management – which was forwarded by Mr. Whitney Tilson to the Seeking Alpha website. This was the company that suggested that Microsoft buy back a massive amount of stock and borrow some $40 billion to do so. In the analytical framework of my company, this comes down as being a short term, highly self-serving recommendation triggered by the desire to hype the MSFT stock in the short term, presumably so that they can get out with some nice quick profits. This is not sound capital markets policy.
To start with, X Investment Management is confusing ‘adding value’ with ‘buying back stock’ as if the act of buying stock back adds anything to the value of the company. If they want fewer shares outstanding, why not recommend a 1:2 consolidation? Or is it just that X Management thinks that if MFST buys back stock, that very act will cause the shares to go up? In other words, perhaps they think that if only there were a large-scale buyer of the shares, the current shareholders would get a better return in the short term. This recommendation is not surprising as it comes from a hedge fund which is only interested in the very short term anyway, and has no interest in the long term health and value of the company.
But let’s look at a share buyback with some objectivity. MFST is currently selling at a little over 4 times its book value. For every $1.00 of its cash spent in buying the outstanding stock, the company’s remaining shareholders get back $0.25. That means – to me – the company ‘earns’ an immediate ROE of -75% on its ‘investment’. Trying to increase the share valuation (price) in the marketplace by decreasing the book value strikes me as simply being stupid. Now it is true that there will be fewer shares outstanding and therefore the ROE on its remaining share capital will rise, although very, very modestly, but certainly not enough to offset the massively negative ROE on its repurchase stock ‘investment’. Buying back shares does not add value to the corporation and in our long experience, the resulting decline in book value actually hurts the valuation of the shares in price/book terms.
Who wins in this scenario? I would guess the brokers that bought the shares back for the company might, although given today’s commission rates, not by very much. Long term corporate investors lose because they do not get value for money spent and the incremental ROE on the remaining shares is tiny. Perhaps the hedge fund boys get a short term pop and then they can go on to bug some other company, but this does not add much, if any, long term sustainable value of MSFT for the rest of us.
Second, why trash this (or any) balance sheet by adding a ton of debt to it? High tech companies need strong balance sheets because of the risks of technical obsolescence and strapping on debt for the sake of strapping on debt is very short-sighted. However, it is true that this company appears to have a lot of excess cash on hand. In our valuation methodology, we observe that the market does not pay management to sit on their assets, but to work them. The management of MSFT is clearly working their assets, as evidenced by their high ROE. But it does strike me that the shareholders are not getting enough of that ROE reward, and cash continues to build up at a far more rapid rate than the company is able to actually put to productive use.
In this case, two ‘remedial’ actions stand out, both of which add value to all shareholders in both the short and long term. The first may be to pay out an extra dividend and get rid of cash which the company deems to be excessive – whatever amount that might be. The second would be to increase the dividend payout, perhaps to something like 40-50% of earnings. With a basic ROE of 43% (using the current consensus earnings forecast), the growth in book value of the company would still be a healthy 21.5% and the dividend yield of something in the of 4.6% at the current price would add significantly to the attractiveness of the shares, again at current prices.
Both actions are likely to add value to the current share price, and of the two, I prefer the permanent dividend policy as being the most attractive to current and potential shareholders.
In summary, if I were Microsoft, I would tell X Management to take a hike. But I would also consider taking action which does add long term value for all of the existing holders of MSFT shares.
C. Ross Healy,
Chairman and CEO
Disclosure: We have advised clients on the purchase of MSFT, although our firm does not buy or sell equities.