Microsoft: Just Another Company

Earlier this week, Microsoft issued long-term debt for the first time in its history, selling $3.75 billion of  5-, 10-, and 30-year bonds. From a corporate finance perspective, I guess this makes sense, since it got to lock in historically low borrowing rates. Treasuries are low, and Microsoft paid only about one percentage point more than the U.S. government, which makes sense since it does have over $20 billion in cash, no other long-term debt, and – let’s not forget – a virtual monopoly on computer operating systems and basic desktop software. (In some ways, Microsoft looks like a safer place to lend mone than the U.S. Treasury, except for the ability of the latter to print its own money.) But it’s still a little sad.

First, we have an (optional) Corporate Finance for Beginners interlude:

There has been a ton of research on the optimal “capital structure” for companies, meaning the ratio of debt to equity. Conceptually, companies raise money from two sources: debt (selling bonds) and equity (selling common shares). Debt, as we know, has to be paid back; equity doesn’t. In the 1950s, Franco Modigliani and Merton Miller proved that, under certain (quite large) assumptions, the capital structure of a firm doesn’t matter. In the real world, however, there are a number of reasons why it should.

The simplest question is probably why any company would borrow money that it doesn’t need. After all, Microsoft has over $20 billion in cash, and it continues to make money. Taking on unnecessary debt isn’t something that I would do in my personal finances. But the idea is that companies are different: all of their money comes from and eventually belongs to someone else – for convenience, let’s call them bondholders and shareholders – so it’s just a question of which source is better. For one thing, a company could simply raise money by selling bonds, and then turn around and give the money to its shareholders. So from one perspective, you should ask the shareholders if they would rather have more cash in their pockets, or own a company that had less debt and was therefore worth more.

One major consideration is taxes. (The simple form of the M&M theorem assumes no taxes.) The interest on bonds is tax-deductible for the company, while dividend payments to shareholders are not; they are paid out of after-tax income. So in that sense debt financing is cheaper than equity financing.

But the broader issue has to do with the cost of capital. The cost of debt is pretty simple – it’s the interest rate you have to pay on the bonds. But the conceptual point is that equity has a cost as well – it’s the rate of return that shareholders expect to get by buying common stock. The higher that required rate of return, the less they will pay for your shares, and the more expensive it is to raise money by selling shares (because you need to sell more shares to get the same cash in return). Even if you (like Microsoft) have enough cash on hand that don’t need to sell shares, you could be using your cash to buy back shares on the market; by not doing so, you are implicitly “selling shares” and paying the cost of equity. That’s the concept, at least; trying to estimate your own cost of capital can be very difficult, and trying to estimate the cost of capital for a marginal transaction is pretty close to impossible.

Now, back to Redmond.

A company like Microsoft – with no debt, lots of cash, and a highly profitable business – has an extremely low cost of debt. If Microsoft took on a huge amount of debt, that cost of debt would go up, because investors would see that debt as riskier; the more debt you have, the higher the risk that you will default. But given where they are on the curve, the textbook answer is that they could afford to take on some debt.

But what is Microsoft going to do with that extra cash? There seem to be two main theories: (1) buy back more shares than it is already buying back and (2) buy companies.

I’ve never fully understood why some people think that buying back shares is always a good thing for shareholders. If your market value is $100, and you use up $10 in cash to buy back shares, then it’s true that there are 10% fewer shareholders that the value has to be divided between; but it’s also true that your company is worth exactly 10% less. In practice, share buybacks can boost share prices because they act as positive signals: if the company thinks its stock is underpriced, then maybe it is. But I don’t see how it can work as the long-term strategy that some companies, like IBM, think it is.

As for buying companies, Microsoft already had enough cash to buy any company that could actually have benefited by being bought by Microsoft. Sure, Yahoo! and SAP are out there, but they’ve already done all the innovation they’re ever going to do; from this point these companies are just playing a game of adding their earnings together and trying to minimize the number of shares to divide them by.

In short, issuing debt looks like just the latest step on Microsoft’s way to being a company that uses financial engineering to boost its share price rather than inventing new products. Now I know that Microsoft has thousands of very smart and ambitious employees, so the fact that it has become a sinkhole where talent goes in and nothing new comes out is sad. The simplest explanation is probably that Microsoft is not too big to fail (although maybe it is – what would happen to our economy if nobody were around to fix security holes in Windows and IE??!!), but simply too big to manage. In addition, software has a tendency to get more and more unwieldy and difficult to modify as it gets bigger and older, and Windows is one of the biggest and oldest programs around.

So maybe it’s a smart move. But it isn’t anything for Bill Gates to be proud of.

Update: Microsoft credit default swaps are trading at 37.5 basis points – 2 basis points higher than U.S. Treasuries, and lower than just about every other sovereign government except France, Germany, Finland, and Norway.

By James Kwak

31 responses to “Microsoft: Just Another Company

  1. Didn’t Microsoft give a chunk of cash back to shareholders in a big one-time dividend in 2004? How does a dividend like this differ from a share buyback? And aren’t there companies that borrowed in order to buy their own shares, only to later regret it because of the debt burden and the difficulties of rolling this over now?

    And what is it about high tech companies and their cash piles? Do they hoard cash because they want to be able to weather rapid change in their industry?

  2. If your market value is $100, and you use up $10 in cash to buy back shares, then it’s true that there are 10% fewer shareholders that the value has to be divided between; but it’s also true that your company is worth exactly 10% less.

    I do not think this is true. If your book value is $100, and you spend $10 buying back shares, then your book value will be exactly 10% less.

    But market value is not the same as book value. And neither is necessarily the same as intrinsic (i.e., long-term economic) value.

    Repurchasing your own company’s shares is not fundamentally different from purchasing some other company’s shares. It is a good idea — i.e., it increases value for your shareholders — if and only if those shares are underpriced by the market.

    By taking on debt, Microsoft is signaling that (a) they believe will have opportunities to earn a good return on all those billions eventually; and (b) they do not believe they will be able to borrow at these rates by the time those opportunities appear. Either of those beliefs could be wrong, of course.

  3. If interest rates pick up, Microsoft will be able to buy its bonds at a discount, retire them and book the profit. That may not be the plan but it makes an interesting inflation hedge.

    Separately, Berkshire Hathaway ($22.7 billion cash) is issuing $400 million of three year bonds.

  4. A rather harsh take on a straightforward tactic — leverage. In fact, surprised that word didn’t come up once in this entire post. I guess levering a company is “financial engineering”; it’s also a wide-spread practice, used by everyone from stock traders making margin transactions to students borrowing their tuition.

  5. Yahoo! and SAP are out there, but they’ve already done all the innovation they’re ever going to do; from this point these companies are just playing a game of adding their earnings together and trying to minimize the number of shares to divide them by.

    Now I know that Microsoft has thousands of very smart and ambitious employees, so the fact that it has become a sinkhole where talent goes in and nothing new comes out is sad.

    Yikes. I won’t get into my own opinions on these companies, but it does seem rather presumptuous to suggest that they are strictly done adding value to society at large.

    That said, your scorn for elaborate accounting and corporate financing schemes is greatly appreciated.

  6. They aren’t always a good thing for shareholders. They can boost earnings metrics without there being an actual improvement in operating performance.

  7. I agree with Nemo. Buying back shares can be very good for continuing shareholders if the current market price-per-share is significantly below the intrinsic value (the net present value of future cash flows to shareholders), and bad in the opposite case.

    Corporate management is in a good position to know when buy backs should occur, but I don’t think most businesses use them wisely. In fact, executives with options have incentives to ‘invest’ retained earnings in overpriced buybacks. Buffet has written a lot on this subject.

  8. Unless you are in liquidation mode, as an enterprise you always take what the capital markets offer. Right now they’re offering free money. Why in the world would any rational manager pass up this opportunity?

  9. In the simplest and probably most cynical terms, share buybacks are just a means to increase demand so that an increase in supply (insiders or others selling out [see XOM]) can be absorbed.

    This may not apply in MSFT’s case unless the soon announce an increase in their share buybacks, but share buybacks have always seemed like an easy way for executives to manipulate the market for the company’s stock in a manner that would benefit large holders who wanted out in size.

    Of course, I may be missing something since no one else ever mentions this, but I think it is not because I am wrong, but because others are just not cynical enough.

  10. In short, issuing debt looks like just the latest step on Microsoft’s way to being a company that uses financial engineering to boost its share price rather than inventing new products. Now I know that Microsoft has thousands of very smart and ambitious employees, so the fact that it has become a sinkhole where talent goes in and nothing new comes out is sad. The simplest explanation is probably that Microsoft is not too big to fail (although maybe it is – what would happen to our economy if nobody were around to fix security holes in Windows and IE??!!), but simply too big to manage. In addition, software has a tendency to get more and more unwieldy and difficult to modify as it gets bigger and older, and Windows is one of the biggest and oldest programs around.

    IOW a standard milestone in the evolution of any sector/big company from capitalism (loosely defined here as the stage where something was organically developing, gaining new ground, innovating in the non-Orwellian sense of that word) to corporatism (financial and political manipulations, digging in and entrenching, defending vested interests; rent-seeking).

    It stands to reason – once you attain basic monopoly there’s little value to be added. Any fiddling you do with your core product is likely to be makework, fixing problems which were intentionally created in the first place, needlessly adding complexity, digging holes in order to fill them up again. You can try to extend vertically or horizontally, but almost without exception you have no new value to add; the only goal is anti-competition and simple totalitarian expansion for its own sake.

    As for these share price manipulations, here too the rent-seeking goals are to generate free good PR in the business press without having done anything, and perhaps manipulate the value of exec compensation packages where these include stocks and stock options, as well as the portfolios of prospective future employers.

    I’ve never fully understood why some people think that buying back shares is always a good thing for shareholders. If your market value is $100, and you use up $10 in cash to buy back shares, then it’s true that there are 10% fewer shareholders that the value has to be divided between; but it’s also true that your company is worth exactly 10% less. In practice, share buybacks can boost share prices because they act as positive signals: if the company thinks its stock is underpriced, then maybe it is. But I don’t see how it can work as the long-term strategy that some companies, like IBM, think it is.

    The obvious thought this brings is that, just as in the (very similar) FIRE sector, there’s a disconnect between the short term interest of insider cadres and the long term for everyone else.

  11. Quote: I’ve never fully understood why some people think that buying back shares is always a good thing for shareholders. If your market value is $100, and you use up $10 in cash to buy back shares, then it’s true that there are 10% fewer shareholders that the value has to be divided between; but it’s also true that your company is worth exactly 10% less. —–

    Potential answer: it is because 10$ of company’s cash account is not valued at “face value” by potential equity buyer. 10$ would be valued at ‘face value’ (as $10) by equity buyer only if equity buyer had direct control over those 10$ once he buys the equity and could, at will, transfer his share of the company’s cash to his deposit account (without tax consequence). Otherwise, why would anyone transfer 10$ from his deposit account to get weakest claim (meaning after company’s management, bondholders, etc) on 10$ in company’s cash account when that $10 in company’s cash account is controlled by others and may end up in CEO’s pocket as a bonus, it may be malinvested due to incompetence or corruption, or end up in bondholder’s pocket in the case company goes into bankruptcy, etc etc?

    Now, when company buys back shares they basically value 10$ from company’s cash account at ‘face value’.
    To see this consider your example: Market value of the enterprise is $100 (assume 100 shares, hence $1 per share) with $10 in company’s cash account allocated for buyback.
    Equity buyers value those $10 at some discount for reasons I mentioned (let us say at $7, thus remaining $93 is how they value remainder of the enterprise and let us assume that this value is independent from those $10 in company’s cash account that are to be used for share buyback). If $10 are spent on share buyback we get that 10 shares are bought. However remainder of the enterprise should be valued the same as before (due to independence on $10 sitting in cash account; this may be incorrect assumption in some cases), so remainder of the enterprise should still be valued at $93 and there are 90 shares outstanding. Hence you get more than $1 per share. Hence share buyback is always good for shareholders in the sense of having positive effect on the price of individual share.

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  13. The interest on bonds is tax-deductible for the company, while dividend payments to shareholders are not; they are paid out of after-tax income. So in that sense debt financing is cheaper than equity financing.
    Should governments seek to eliminate this tax deductability, to reduce perverse incentives like this? As an added bonus, it might rise some extra revenue.
    If they did, they would surely have to offer several years’ warning, so that firms that are heavily leveraged are warned of the loss of their tax advantage, and can do something about it.

  14. I suppose Ballmer/Gates have been reading about Stinnes lately. This is almost certainly money destined for acquisitions. Microsoft seems to be placing a bet, albeit small for its size, on extremely high inflation down the road, which, if it indeed materializes, will greatly reduce the value of the money raised as debt in real terms (i.e., purchasing power). Refer to the actions of Hugo Stinnes, a prominent German entrepreneur during the Weimar Republic, who had enormous success taking debt to build an empire out of acquisitions. The debt he took was later paid back in worthless marks before the retenmark was introduced. Perhaps we too should be shifting a little attention from 1932 to 1923.

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  16. Warren Buffett points out that a rational company management returns excess cash to shareholders if the company cannot earn an above market return on that cash. (It’s interesting to note that Berkshire Hathaway does not pay a dividend and has not bought its own equity in years.)

    Back when MS started paying dividends, they probably concluded that their expansionary days were through. And I give them credit for being rational.

    Given that one of MS’s largest customers was the financial industry, it’s easy to see why their business has less growth potential today than it was when MS dividends started. (As a side note, Bill Gates once commented that MS’s biggest competitor in the employee/talent market was not Oracle, Google, or other software companies, but Goldman Sachs.)

    So, why borrow the cash now? They’re either about to make some large acquisitions, like Yahoo, or their internal projections for the future suck even harder than we realize. Probably both.

  17. The way to make money in the US has always been through monopoly power. The way for a big company to become small in the US has always been for it to move beyond its area of specialty.

    Microsoft now still has monopoly pricing power and the wise thing for it to do – all ego and silly hope aside – is to ride it out and make what it can while it lasts.

    Buying up companies exposes them to government anti-monopoly attention; trying to out-innovate the small inventors and promoters will be a loser every time.

  18. Did anyone think Microsoft was NOT just another company?

  19. le grain de sable

    smells like the end of a business model to me(a bit like the roman empire) since xp it’s been all downhill.microsoft is no sony, it’s a one (technological) shot.

  20. It seems to me that the preferred tax treatment of share buy-backs (cap gains) vs dividends (ordinary income) has been ignored.

  21. Ed in Palo Alto

    Smart move, Microsoft !

    Like many other well-thouhgt-through moves you have made: The money you pay back in 1 year will cost a LOT less than what it is worth now !

    In other words, rate will increase, and your bonds will, over the next year, become much lower cost bombs you can buy back for a cool 50% profit on your money !

    If it were my choice, I’d sell twice as many !

  22. Sure, they’d receive some anti monopoly attention — but how do we know that the government would care enough to actually prevent a deal, especially one that does not extend the MS monopoly ( http://en.wikipedia.org/wiki/List_of_companies_acquired_by_Microsoft_Corporation#Acquisitions ) ?

    Anyway, it seems most anti monopoly buzz today centers on financial companies.

    What am I missing here?

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  24. it makes sense for microsoft to borrow money and buy companies if they think that these companies are cheap and if they are committed to keeping a large cash position.

  25. This is a remarkarbly superficial analysis of the topic. Construct a spreadsheet and assume some reasonable rate of growth and run it out for 5-10 years and see what kind of value accrues to shareholders vis a vis a capital structure of all equity. Yes, the capital structure has a higher risk profile, but there is a tradeoff that shareholders should be willing to make, up to some point of risk.

    Have you ever heard of WACC and EVA? I don’t think you understand how value accrues to shareholders when you lower the cost of capital. I expected more from this site.

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  28. microsoft is a paravane company of PENTAGON

  29. Or it could be that they replaced all their good American developers with crap Indian programmers who have destroyed the code.

    Funny, but BSD is a lot older than Windows, and OS X on which it is based is totally superior. There goes that argument.

  30. “For one thing, a company could simply raise money by selling bonds, and then turn around and give the money to its shareholders.”

    Now where did I see that chart? Angry Bear, perhaps. It was a comparison of total dividend payments made by some companies, over the past decade, versus total borrowing by those same companies over the same period, and indicated that this is exactly what those companies were doing. Every penny of dividends, and in some cases more, was borrowed.

    As James’ article points out, this is not necessarily a bad thing, if it was part of a well-thought-out adjustment of the debt-to-equity ratio. But as I recall the original chart and analysis, for at least a few of the companies it was just a way to meet analysts’ expectations for the dividends.

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