What Does The LinkedIn Acquisition Mean For Microsoft's Dividend Investors?

| About: Microsoft Corporation (MSFT)

Summary

Microsoft’s acquisition of LinkedIn is a big bet on its Cloud Computing platform.

The LinkedIn acquisition will be financed with debt and have no impact on its ability to pay a dividend;

Despite some short-term earnings dilution, the acquisition positions Microsoft better for the future and we expect the stock to trade up to at least $60 in the next 12 months.

On June 13, Microsoft Corp. (NASDAQ:MSFT) announced that it was acquiring LinkedIn (NYSE:LNKD) in a deal that had been quietly percolating since February. This article covers the impact the acquisition will have, if any, on Microsoft's dividend.

The LinkedIn acquisition is anticipated to dilute Microsoft's earnings by around 1% in the near term but is expected to provide an earnings boost by Fiscal 2019 (i.e. from July 2018-onwards). As such, it's only natural that dividend investors be concerned about its impact on Microsoft's dividend. Indeed, Moody's is reviewing Microsoft's 'AAA' credit rating for a possible downgrade - even as its rival, Standard & Poor's reaffirmed its 'AAA' rating on the software giant.

We believe that Standard & Poor's has the right of it. In our view, Microsoft's dividend is unlikely to be impacted negatively by the LinkedIn acquisition. Microsoft announced that it will pay for 'most' of the acquisition with debt rather than tapping into its $105 Billion cash horde (most of which is overseas) or issuing new shares - so there won't be a significant drawdown on Microsoft's cash in the short term. In fact, Microsoft indicated that the transaction would not affect its massive $60 Billion stock buyback program - so the deal's also unlikely to impact its much smaller dividend program.

Nonetheless, it's worth examining the numbers: based on Microsoft's latest SEC filings, it pays a weighted-average coupon of 3.15% on its various long-term debt obligations. Were Microsoft to finance all of the LinkedIn purchase through similarly-priced debt, it would pay around $712 million in interest per year to finance this deal.

While substantial on an absolute basis, this amount is small in relation to Microsoft's vast resources. To elaborate: Microsoft has a working capital ratio of 2.9-to-1, which means that it has nearly $3 for every $1 of short-term obligations such as interest. Adding another $712 million in accrued interest would reduce its working capital ratio to 2.85-to-1, hardly moving the needle in practical terms.

It's also important to note that taxes were Microsoft's primary reason for choosing to finance this deal through debt. Microsoft would have had to repatriate nearly $35 Billion from its overseas cash reserves just to pay for LinkedIn since over $12 Billion of that amount would have gone towards paying taxes (at a 35% rate). Even if Microsoft were to issue 10-year notes to finance the acquisition, the cumulative interest would amount to approximately $7.1 Billion - or $5 Billion less than the alternative.

Furthermore, the interest that Microsoft would pay on any LinkedIn-related debt would be tax-deductible, thereby reducing its tax bill further. In the example we provided, Microsoft could create a cumulative tax buffer of nearly $2.5 Billion over a period of 10 years (i.e. 35% of $7.1 Billion) just from the interest it pays to acquire LinkedIn rather than using its cash.

In the long run, it's in the best financial interest of Microsoft's investors and shareholders to finance the LinkedIn deal through debt.

One other aspect of the deal to note is that LinkedIn will continue operating as a separate unit from Microsoft. This is significant because, on its own, LinkedIn is very strong financially (with a 3.3-to-1 working capital ratio) and unlikely to require any cash infusions from Microsoft that impedes its ability to pay a dividend to shareholders.

What's more, to the extent that Microsoft is able to successfully monetize LinkedIn users' data, it can expect a boost to both its revenue and earnings. To wit, while Microsoft's revenues are expected to grow by 8.25% over the next 5 years, which is around half the growth rate for its industry. A successful integration of LinkedIn that significantly boosts the growth of its fast-growing Cloud Services unit will enable Microsoft to close this gap, generate more cash flow - and potentially raise its dividend.

Conclusion

It is only natural that acquisitions such as LinkedIn will draw criticism from some but we see this acquisition as Satya Nadella making his biggest bet on the Cloud yet. Unlike its previous ill-advised bets on Mobile, Microsoft is working from a very strong position in the Cloud, competing directly with Amazon for supremacy in the Cloud Computing space.

At a 2.8% dividend yield, Microsoft has among the highest dividend yields in its peer group and we've presented the case for why we do not expect Microsoft to reduce its dividend anytime soon. As such, investors who buy 100 shares of Microsoft at its current price can expect at least $144/year in passive income.

Beyond this, it's worth noting that despite the run-up in its stock price, Microsoft is trading at a forward Price-Earnings ratio of just 17.4x - a discount to the forward earnings multiple of 17.9x for the S&P500. Microsoft's forward multiple does not yet include estimates from the LinkedIn acquisition - so it can be argued that, given the expected future impact on this transaction, there is room for Microsoft's share price to rise to the median of analysts' forecasts - $60 per share - in the next 12 months.

Disclosure: I/we 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.

Additional disclosure: Black Coral Research, Inc. is a team of writers who provide unique perspective to help inform dividend investors. This article was written by Jonathan Lara, one of our Senior Analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article. Black Coral Research, Inc. is not a registered investment advisor or broker/dealer. Readers are advised that the material contained herein should be used solely for informational purposes. Investing involves risk, including the loss of principal. Readers are solely responsible for their own investment decisions.