Tuesday, May 28, 2002

It's better to be a star than a cow Let's face it, tech companies mature too. Although the Microsofts, Oracles, Ciscos, Siebels etc. of this world like to believe they're in the innovation business, they're actually in the PC OS, RDBMS, router, or CRM business, and once you've won the market you're done. But your shareholders and employees have drunk the innovation Kool-Aid, "mature" sounds suspiciously like "stagnant", and hey, you've paid out all these options promising high growth you have to be a middle manager or a Wall Street analyst to still beleive that.

After an initial product innovation, organizations specialize around processes to take that innovation to market. This makes them uniquely unsuitable to new product innovations which is why the Valley (and the world) has few companies who have successively taken genuinely innovative products to market. On paper, this looks like companies with no debt and lots of outstanding options accumulating large cash hordes. I had an excellent conversation with Ed Gilmartin about Microsoft's financials, which I've printed below. Even better, Ed calculated how much tax Microsoft could avoid by buying back shares, so I didn't have to. Great stuff.
In the 5 years to 30 June 2001 (sourced from MS's 10K filings and using cumulative figures for brevity), MS reported a profit before tax of approx. $50.1bn in total. In the same period it actually paid $5.2bn in tax - a tax rate of about 8.5%, and much lower than the prima facie tax rate in the accounts of about 34.5%. The reduction came because the company received tax rebates totalling $13.1bn due to its option program. This is a large rebate! In fact in the year to 30 June 2000 MS reported a pre-tax profit of $14.3bn and received a net tax rebate of $700m - it paid no tax, but in fact was paid $700m by the tax office!! What you say about debt reducing tax is right, but they seem to be doing OK in reducing tax & debt also has a cost in the form of interest - and, efficient market theory/Miller Modigliani etc would argue that company capital structure doesn't make a difference to value.

In the same 5 year period the company repurchased $19.5bn of stock. These guys are "super smart" in the words of the chief technology officer - they are paying a very low tax rate AND returning $$$ to shareholders.

I have not looked at the figures in detail but, in its last 10K, Cisco reported net cash and short term investments of about $7bn (no debt), Dell had $3bn or so reported in its last 10K - there is a pattern here - it is not just MS who is throwing off more cash than they can deal with. The others also have large share buy-back programs, so they are giving some back to shareholders. This looks like a wider situation than just MS "out of ideas" (although that may still be the case, see below); it seems to be a generation of large successful companies are throwing off cash and sitting on it. This could be caution (retaining option value to buy into the next big thing), the fact that (as you point out) dividends just don't make sense, the fact that they are all out of ideas, or some other reason that I can't articulate.

Ms's lack of investment opps. requires a long email of its own. Suffice it to say that they need X-Box to work, they need .Net to work, they need the Navison & Great Plains acquisitions to work; in fact they need everything to work to keep their growth rate up. What they seem to have become, as it turns out, is a cash cow - kudos to them for not behaving like other cash cows in the past & throwing their cash away (cf. big tobacco buying into food & then having to get out etc.) - but they are suffering the not unusual fate of the growth star that turns into a cash cow and then stays in denial about that fact, 'cos lets face it it's better to think of yourself as a star than as a cow.......

I think you are right that the cash pile signifies that MS is bereft of ideas (but I bet that most folks in the financial markets (if not the employees) know this too, it's just not in anyone's interest to point it out, especially while .Net etc seem to "promise" at the moment), but I'm not sure that's the whole story (see pt4 above).

Regarding their buying back shares, I'm not sure what the rules are in the US (UK & Australia are my areas), but there is usually a limit (10% or something) to how many shares a company can buy-back in any year without getting special shareholder approval - I'm not sure whether MS are near their limits - but if they need to get this approval it all gets very public & they probably have to publish a circular with reasons etc, so the lack of growth issues you allude to could get dragged into the open.

Also, bear in mind when you look at MS taking on debt/reducing cash that there is no real point in them going tax negative - they would reduce interest income or even go into debt through buying back lots of shares only to the extent that they could get the tax to zero, and since they are only paying 8-9% tax, that is all they have to play with. (Again, though, I'm not 100% sure how the option tax works: if it is actually a stand-alone cash rebate rather than a charge against taxable income, they may be able to get the option rebate & still have all their profit to service debt (although I would guess this is not likely).)

Finally, on the back of my envelope, (I'm jumping, so this may not be clear....), I would calculate as follows:

- MS had $38.7bn in cash and short term investments as at 31 March 2002; this could all be used for a share buy-back. - Assuming they have an EBIT of about $12bn (their 2001 number was $11.7bn), an EBIT/interest coverage ratio of 5-6x would be comfortable, so they might take on long term debt of about $40bn (assuming 5.5x interest cover and long term interest rate of 5.5% - they would not be raising this at the Fed. short term rates, but closer to the 10yr bond rate + a small margin).

- They could therefore buy back about $80bn of shares (as you note, much higher than what they actually bought).

- However, assuming their EBT was $14.1bn ($12bn EBIT + interest on the $38.7bn cash also at 5.5% for simplicity), and assuming they have 8.4% of tax charge to play with (ie. their 5-year average tax charge after option rebates, reduced from a prima facie tax charge of 34%), they could afford to reduce interest income/take on debt interest to the tune of $3.5bn (8.4/34*14.1); ie they could do a buy-back of "only" $63.6bn ($3.5bn of interest at a 5.5% rate) before they ran out of tax capacity.

PS. MS says in their 2001 10K that the value of options outstanding at that time was $66bn - there are a lot of those suckers still out there at attractive strike prices!!
Couldn't have said it better myself. To summarize: Microsoft's a mature company, but it's not acting like it. It's avoiding tax by exploiting sloppy option accounting rules (like everyone other tech company in the US), avoiding tax disadvantaged dividends, and has enormous hidden compensation liability (which it will renege on--watch for disgruntled employees trying to get theirs out of the cash horde, screwing current employees, who will end up taking whatever they can get from the cash horde).


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