Monday, May 11, 2009

Hey Microsoft, Use Debt Sale for M&A

05/11/09 - 12:25 PM EDT


Eric Jackson

This morning brought news that Microsoft(MSFT Quote) will be selling five, 10-, and 30-year debt as soon as perhaps later today. This makes a lot of sense. Microsoft has been overly conservative in how it's managed its business since its founding, due to the personal biases of Bill Gates.

Investors couldn't complain in the early days, but the last 10 years have been grim from a shareholder-return perspective. Even when you count the dividends you've received as a shareholder Redmond initiated that program in the early part of this decade, you still have seen total shareholder returns of almost -50% from holding Microsoft for 10 years -- far below the Nasdaq and Microsoft's chief competitors like IBM (IBM Quote), Oracle (ORCL Quote) and faster-growing Apple (AAPL Quote) and Google (GOOG Quote). That's depressing for Microsoft investors and employees alike.

From a capital structure perspective, Microsoft's antipathy toward debt has always puzzled investors. Here is a dominant franchise, with perhaps the most pristine balance sheet in the world and a remarkable cash-generating ability, and yet it still keeps an enormous amount of cash on its balance sheet and refuses to use debt.

There are two open questions regards this debt issuance announcement: (1) How much debt will they issue? and (2) How will they use it?

If Microsoft's history holds, the amount of debt issued through this will be modest. They've indicated that the offering will be "benchmark" size, which indicates at least $500 million. If you compare the debt-to-cash ratios of larger peers Oracle and IBM, Microsoft should be looking to issue much more than that. Oracle has an equal amount of cash and debt, implying that Microsoft should look at taking their debt load to $24 billion. IBM uses debt even more aggressively. IBM's debt-to-cash ratio implies that Microsoft could take on $60 billion in debt easily.

If Microsoft does announce that it will raise a lot of debt, that news alone will likely send its shares lower. The market might figure it plans another high-ball offer for Yahoo! (YHOO Quote) or to take over Facebook at the $16 billion valuation Microsoft agreed to at their last round. How the market interprets the amount of debt Microsoft raises very much depends on how they will spend it.

Microsoft has begun buying back stock in the last five years and currently has an open plan to buy back an additional $40 billion in stock between now and 2013. For years, several Microsoft investors have called on the company to buy back stock as a way of reducing the amount of cash inefficiently sitting on its books to its investors.

Microsoft has obliged over the last five years, using about $100 billion in capital to pay shareholders dividends or buy back stock. Yet that strategy has led to total shareholder returns over that period of about -25%. To be fair to Microsoft, the simple strategy of dividending out cash to shareholders and buying back stock hasn't worked out for many companies over the last two years, as companies like Microsoft and Sears Holdings (SHLD Quote) have watched billions of dollars of their capital used to buy back stock at now-inflated prices.

Continuing to just buy back more stock is not the answer for Microsoft's low stock price. The company needs to give its investors a strategy for how it is going to grow. Investors are currently pricing in the likelihood that Microsoft will essentially run itself like a utility for the next 20 years -- as well as spend money in areas like search or the Zune, which will never return the capital spent. They believe Microsoft's top line will stay flat.

Microsoft management has given investors no reason to believe otherwise. We've heard little to excite us about the future growth of this company, more about its obsession with getting a deal done with Yahoo! and catching Google. That's not a corporate strategy.

The status quo isn't working at Microsoft. There needs to be a plan for growth at Microsoft, and it needs to involve acquisitions. The business press is littered with articles about how IBM, Oracle, and Cisco(CSCO Quote) will be using their strong balance sheets to pick off once-in-a-generation priced acquisitions in the next year -- yet Microsoft's name is never mentioned as another suitor. With its cash-generating ability and more capital from a debt offering, it should be in the mix.

To be successful in the long run, Microsoft needs people to green-light the best acquisitions and teams of people with the right skill sets to integrate them. Frankly, Microsoft hasn't shown it has either of those abilities. Microsoft investors don't need another expensive aQuantive deal or Facebook investment that smacks of desperation and has questionable long-term value for the company's shareholders. It needs to take a page out of IBM's and Oracle's playbook, though, and start doing deals to grow its top and bottom lines.

A big debt issuance, with a skilled acquisition team, and evidence of some exciting growth-related deals could suddenly show the market that this elephant can dance again.

At the time of publication, Jackson was long Microsoft.

Eric Jackson is founder and president of Ironfire Capital and the general partner and investment manager of Ironfire Capital US Fund LP and Ironfire Capital International Fund, Ltd.

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