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Microsoft: ValueAct Investment Will Provide The Catalyst For A Buyback
Disclosure: I am long MSFT.
The potential for a significantly accretive buyback has increased due to ValueAct's recent $2 billion purchase of Microsoft (MSFT) shares.
Background
ValueAct is a very successful activist hedge fund with ~$12 billion in assets based in San Francisco. The firm is led by Jeff Ubben and has a long list of successful activist roles including Motorola Solutions (MSI), Adobe (ADBE), and Gardner Denver (GDI). Prior to ValueAct, Mr. Ubben worked at the successful activist shop Blum Capital. The fund takes a collaborative approach to activism with more talk behind the scenes than on camera. It avoids confrontation tactics unless it is crucial to unlocking value. A list of ValueAct's other holdings can be accessed here.
Buyback -- Potential for Significant Accretion
MSFT has one of the best balance sheets in the world and has the capacity to buy a significant portion of its stock. There are many tech companies that trade at very low valuations with solid balance sheets. These include ORCL and AAPL. There is a disconnect in the markets. When a company can buy its own stock at 10%+ FCF yields and borrow at less than 5%, there is a huge arbitrage that can be taken advantage of via buybacks.
MSFT knows itself so even if EPS does not grow in the future, the buyback will be accretive. If EPS continues to increase, the accretion will be even greater. In general, you are buying stock at 10%+ FCF yield and borrowing for well under 5% especially when you adjust the interest expense by the tax shield.
I have tried to illustrate below four different scenarios.
- The first column represents no buyback and using consensus estimate for FY 2013 EPS.
- The 2nd column represents a buyback of $68 billion of cash. This leaves MSFT with $10 billion in cash and generating FCF at $25 billion or more.
- The 3rd column represents using $68 billion in debt to buy back shares at the current price.
- The 4th column represents if MSFT bought back $68 billion in stock at current prices using 50% cash ($34 billion) and 50% in debt ($34 billion).
| Buy Back | Buy Back | Buy Back | ||
| Current | Cash | Debt | Debt/Cash | |
| Price | $30.80 | $30.80 | $30.80 | $30.80 |
| Shares | 8,330 | 6,122 | 6,122 | 6,122 |
| Mkt Cap | 256,564 | 188,564 | 188,564 | 188,564 |
| Debt | 14,000 | 14,000 | 82,000 | 48,000 |
| Cash | 78,000 | 10,000 | 78,000 | 44,000 |
| EV | 192,564 | 192,564 | 192,564 | 192,564 |
| Tax Adj. Net Inc | ||||
| Int Income | 0 | -204 | 0 | -102 |
| Int Expense | 0 | 0 | 1,632 | 816 |
| Adj. Net Income | 22,908 | 22,704 | 21,276 | 21,990 |
| New EPS (6/13) | $2.75 | $3.71 | $3.48 | $3.59 |
| Accretion | $0.00 | $0.96 | $0.73 | $0.84 |
| P/E | 11.2 | 8.3 | 8.9 | 8.6 |
| Assumptions | |
| Int. Rate - Debt | 4.0% |
| Tax Rate | 40% |
| Int. Rate - Cash | 0.5% |
| Net Income FY13 | 22,908 |
Assumptions
There are many assumptions here so this a hypothetical buyback. Even if you put more onerous assumptions in the calculation, the result is still significant accretion. The only real debate is how much accretion.
One of the assumptions that may be questioned is the interest rate on new debt issued at 4.0%. If you assume 5%, this detracts ~$0.05 from the buyback. The company raised debt ($3.75 billion) in 2009 for ~100bps over 10-year and 30-year Treasuries. I know that I am stating that MSFT would need to raise $34-68 billion of debt, but this illustrates the low cost of debt for MSFT.
Another assumption that may be questioned is that there is $68 billion in cash available. We all know there is a lot of cash overseas and would need to be taxed. I used column one to show what would happen if there was a tax holiday allowing MSFT to repatriate its cash offshore. Also,David Einhorn recently proposed to AAPL that it could issue preferred shares and use this cash for a buyback. This did not come to fruition but there are solutions to the offshore cash problem.
Also, the assumption that MSFT can buy all of this stock at its current price. This is not very likely but if the stock price moves up too far it is a "good problem" if you own shares of MSFT.
Again, I understand there are many assumptions, but this exercise highlights the significant accretion that could be achieved.
Conclusion
The significant accretion that can be achieved may be unlocked with ValueAct's investment. There are also many areas of cost savings that have been highlighted in the past and may be highlighted by ValueAct. The arbitrage of buying your own stock with a growing 10%+ FCF yield and borrowing at 4-6% is too tempting to ignore, especially with a well-respected activist on board.
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