If You Own Microsoft (MSFT), Read This

Note from Daily Trade Alert: The following piece is a letter Dan Ferris recently wrote to Microsoft’s board of directors. In short, it addresses a serious issue concerning the stock. This is a “must read” for anyone who owns shares.

Earlier [this month], I sent the following letter to Microsoft’s board of directors…

November 2, 2012

MSC 123/9999
Office of the Corporate Secretary
Microsoft Corporation
One Microsoft Way
Redmond, WA 98052-6399

Dear Microsoft Board of Directors,

I am writing to you today as a Microsoft shareholder.

I never expected to write those words. You see… I’m contractually prohibited from making investments in the equities I recommend to readers of my two monthly investment advisories, one of which I’ve been writing for more than 10 years.

[ad#Google Adsense 336×280-IA]But I recently received permission from my publisher’s general counsel to buy one share of Microsoft so I could attend the annual meeting in Bellevue, Washington later this month and address the board as a shareholder.

It’s my sincere hope that the modest nature of my personal investment won’t tarnish your view of my proposal below.

If I weren’t contractually prohibited from doing so, I would own many more Microsoft shares.

I have been very bullish on Microsoft ever since I first researched the company in the summer of 2006.

Back then, I circulated an e-mail to my colleagues, showing them that the combination of Microsoft’s fortress-like financial condition, its excellent business, and dirt-cheap stock price made it an excellent equity investment at that time. I recommended the stock in my newsletter in October 2006.

I continue to communicate my enthusiasm for Microsoft as one of the world’s greatest businesses… and at recent prices below $30 a share, one of the safest and highest-quality equity investments available anywhere in the world today. I’ve pointed out many times Microsoft’s highly valuable products, its consistent profitability, high returns on capital, enormous cash generation, excellent dividend-paying history, and financial fortress balance sheet. It’s an equity investor’s dream come true.

I’m particularly excited about the recent release of Windows 8 and the new Surface tablet – Microsoft’s first computing device. The negative reviews of Windows 8 appear to be misplaced, though I have yet to try a full version of the new system. My Surface tablet is on order and has yet to arrive. I’m excited about it, because my iPad just doesn’t cut it as a productivity device. I need to do real work in programs I rely on every day, like the Microsoft Office productivity suite. The iPad won’t let me do that. But the Surface will, and I can’t wait to get my hands on it. Bravo to Microsoft’s management team for heading the business squarely in the right direction.

It’s as an enthusiastic supporter of Microsoft’s management, a raging Microsoft bull, and a modest owner of Microsoft equity that I write to you today. I’d like to propose an answer to one important question about Microsoft… a question I’d wager is on the minds of many of my fellow shareholders.

The basic question is simple: Why is the equity of a wonderful business like Microsoft trading at such a depressed market valuation?

I won’t claim to know the one and only answer to this question. But I believe my reasoning speaks for itself and that the opinion expressed below is worth the board’s consideration. I think Microsoft is cheap because there is a large difference between (A) the huge profits earned by the business in recent years and (B) the value created for shareholders during that time. If Microsoft takes certain actions, shares would no longer be weighed down… and the market would finally – and fully – recognize the enormous value created by this business each and every day.

I recognize Microsoft is one of the all-time-great creators of shareholder value. According to data provided by Capital IQ and published on Yahoo Finance, Microsoft’s dividend- and split-adjusted share price increased more than 420 times from its IPO on March 13, 1986 through yesterday. Shareholders who bought at the IPO and held until today have compounded their wealth by more than 25% per annum for nearly three decades. Few corporations can say the same.

I’m not addressing this phenomenal record, which speaks for itself as one of the great investment performances of the last several decades. I’m concerned solely with the current depressed valuation of the shares versus what I see as a large amount of unrealized shareholder value creation.

The unrealized shareholder value creation exists in two forms: the enormous amount of cash and securities Microsoft currently holds… and the enormous amount of excess cash flow Microsoft generates each year.

First, let me address the balance sheet…

As of September 30 – the most recent data available – Microsoft reports over $66.6 billion in cash, cash equivalents, and short-term investments. This accounts for about 54% of Microsoft’s total assets and approximately 97% of its shareholders’ equity line.

The majority of this cash hoard is held outside the United States. According to the annual 10-K form dated June 30, there’s about $60.8 billion held offshore. The deferred tax liability on this amount is approximately $19.4 billion.

I realize most shareholders would like Microsoft to pay the lowest possible tax rate, and earning substantial amounts of profit in lower-tax countries helps achieve that end. So many of my fellow shareholders likely view its massive offshore cash holdings with relative indifference. As I hope to demonstrate, paying the lowest possible tax rate is not a suitable focus for a business like Microsoft. On the contrary, I believe a preoccupation with tax rates is detrimental to shareholder value creation.

Later in this letter, I’ll recommend specific actions Microsoft should take. But my suggestion boils down to this: Microsoft should bring its offshore cash home, pay the U.S. taxes, and distribute the remaining amount to shareholders through dividends and share repurchases.

I realize this is a radical proposal. It probably sounds like I’m suggesting Microsoft light $19 billion on fire. I completely understand this viewpoint. But today, I’d like to offer an alternative viewpoint, courtesy of your neighbor, Seattle, Washington-based logistics provider Expeditors International of Washington (Nasdaq: EXPD). Its example is one I believe Microsoft and many other U.S. corporations should at least consider.

The comparison of Expeditors to Microsoft might not seem appropriate, but there are important similarities. Both businesses earn substantial portions of their operating income outside the United States. Both specialize in knowledge-based products and services, based on their substantial concentrations of expertise and experience relative to the rest of their industries.

Both employ some of the most knowledgeable people in their industries, some of the most valuable executives and employees on the planet. Both have small capital requirements relative to their operating cash flows. Both have excellent, cash-rich balance sheets, consistent profit margins, and consistently large excess cash flows. I believe these common attributes make a comparison of the two companies a worthwhile exercise.

Expeditors does business in 60 countries… yet, since 1993, it has pursued a policy of bringing all its foreign earnings home to the U.S., where they become taxable at U.S. tax rates. Contrary to what some might expect, this policy has not prevented Expeditors from creating substantial shareholder value.

According to data provided by Capital IQ and published by Yahoo Finance, Expeditors’ dividend- and split-adjusted share price has increased by more than 53 times since March 26, 1990, through yesterday. Expeditors shareholders have compounded their money at more than 19% per annum for more than 22 years. That’s a truly phenomenal record. Expeditors has rewarded shareholders with 17 consecutive years of dividend increases. Over the last 10 years, its dividend has risen at a rate of more than 25% per annum.

The obvious conclusion is correct: Bringing home foreign earnings and paying U.S. tax rates in no way prevents a corporation from creating enormous shareholder value.

Expeditors CEO Peter Rose states this case well:

We think working to achieve operational excellence is a far more worthwhile goal than trying to establish your own art form of financial and tax engineering. We also believe, rightly or wrongly, that in the long run, the market pays a premium for sound, fundamentally sustainable operating income… the more people get caught up in trying to structure their international organization to benefit from ridiculously low tax rates, the less their corporate strategy is focused on making money through their core operations by servicing their customers…

We think it’s ridiculous that some companies “mickey” with their tax rates by permanently leaving profits offshore, to the point of having to borrow domestically to fund dividends and domestic operations. That kind of “financial engineering” gaming of the system seems counterproductive to us.

Rose’s point is clear: Operate the business… Build sustainable income… And don’t get distracted by offshore tax rates.

Microsoft isn’t Expeditors. But Rose’s ideas suggest a different – and ultimately more effective – path for corporate boards. Microsoft’s success has been enormous, and its cash hoard seems to be creating a proportionate distraction. The distraction could be eliminated if Microsoft embraced sounder principles of creating shareholder value and ceased to “mickey” with its tax rates by leaving foreign-earned profits offshore. I hope you’ll give this the consideration it deserves.

It also strains credibility to the breaking point that Microsoft has deemed over $60 billion permanently invested offshore. Based on available data, it’s likely that’s more than all Microsoft’s capital spending since its founding in 1975. So I must ask the board another question: Are you certain you can quickly build another Microsoft? Another company with a 90% market share, 76% gross margins, 23% net margins, and a $248 billion market cap? Another 400-bagger for investors?

Answering “yes” to these questions would be the only justification for keeping $60 billion in shareholder-owned money sitting in offshore accounts and investments. It’s obvious that the only reason Microsoft has deemed this amount permanently invested is to avoid paying U.S. taxes on it. There’s no other credible reason anywhere in sight.

Also, with all due respect to management and the board, it’s unfair to suggest you’re preserving shareholder value by keeping any amount of money at arm’s length from the U.S. taxman. The taxman is incapable of destroying 100% of the dollars you bring home. I wish I could say the same for Microsoft itself…

Microsoft paid $6 billion for digital marketing and service provider aQuantive in 2007. It recently took a $6.2 billion write-down to its Online Services Division (which fails to earn a profit). Microsoft clearly stated the write-down was related to the goodwill from the aQuantive acquisition. In other words, Microsoft made a bad acquisition and lit $6 billion on fire. Shareholder value was destroyed.

If Microsoft earns $6 billion selling Surface tablets and pays U.S. corporate tax rates on it, there will be a lot more money left over than the zero from the aQuantive acquisition. Like the shareholders of the overwhelming majority of U.S. corporations, Microsoft shareholders should fear bad capital allocation much more than they fear the taxman.

Shareholders should insist businesses bring their foreign-earned profits home, pay their U.S. taxes, and distribute the excess to company owners. Please don’t take this as an insult. It isn’t. As I’ve said… I’m a huge Microsoft bull. I have simply learned from experience that capital allocation is a rare skill in the corporate world, even among brilliant business operators like Microsoft. There’s no shame in not having this skill, only in failing to recognize its absence.

I wish aQuantive were the only example… The $8.5 billion purchase of Luxembourg-based Skype in October 2011 looks suspicious. It looks like Microsoft’s foreign-held cash is burning a hole in its pocket. I recently spoke with one of your investor relations representatives about Skype and foreign-held cash. She offered the Skype deal as evidence Microsoft uses offshore money to create shareholder value. I laughed for a second then stopped, as it was a sad commentary on the state of understanding of the fine art of capital allocation up and down the organization at Microsoft. (Again, there’s no shame in that, as long as you admit it.)

On Skype as a capital-allocation decision… I must paraphrase Cuba Gooding from his role in the film Jerry Maguire: Show us the money! As the largest acquisition in company history, company owners deserve to know exactly how Microsoft will make money with a business its previous owner eBay failed to capitalize on… and how that business is worth more than three times in 2011 what eBay paid for it in 2005. Is it that much closer to producing its first penny of net profit?

Fortunately for Microsoft shareholders, it’s one of the most profitable, cash-gushing, capital-efficient businesses on the planet. So at least for now, aQuantive and Skype haven’t had too big of a negative impact. That’s why I remain bullish on Microsoft. Despite its two missteps, it’s still a phenomenal business. If it simply changed its capital-allocation policy, it would be a leader both as an operator and as a creator of shareholder value. That’s all too rare. Also, owning this wonderful business at this price is an easy decision. Now, if it can just take action that’ll help the market realize what we shareholders already know…

Another popular excuse for retaining cash is that it’ll be used to fund future growth. This sort of thinking is a popular myth, especially among technology companies. In a 2003 paper titled “Surprise! Higher Dividends = Higher Earnings Growth,” authors Rob Arnott and Cliff Asness showed that higher dividend-payout ratios were associated with higher earnings growth – the exact opposite of the popular belief.

Put another way, companies with poorer earnings growth records tend to retain more of their earnings. Again, corporations and their owners and boards should be more wary of retaining too much cash, not too little.

The evidence strongly suggests retaining mountains of cash will never get Microsoft or its shareholders anywhere either wants to be. So let’s get real about Microsoft’s massive cash hoard. It encourages bad capital-allocation decisions and results in the destruction of shareholder value. The current depressed valuation of the company’s equity clearly reflects the market’s belief that this destruction will continue.

I’m confident the board can easily understand the point I’m making about shareholder value creation. It’s emotionally difficult. Microsoft is simply being prideful about U.S. taxes and big acquisitions. Human nature being what it is, pride loves company… Microsoft has the comfort of like-minded large technology companies on its side.

Earlier this year, Apple (AAPL), Cisco (CSCO), Oracle (ORCL), and other companies got together to lobby Congress for a tax holiday, claiming this would give them an incentive to bring foreign-held cash home. They claim tax relief would help them “create jobs” and other euphemisms for making capital investments within U.S. borders.

This is utter baloney. If corporations know they can get tax holidays, it provides a clear incentive to continue holding money and developing and acquiring new businesses offshore, where profits will be taxed at lower rates… until the next tax holiday comes around (as it did in 2004), allowing corporations to circumvent the standard 35% corporate tax rate.

The U.S. government should make it crystal-clear no such holiday will ever be considered again. Taking the tax holiday off the table puts the ball back into corporate America’s court, where it belongs. It creates more of an incentive to invest in the U.S. than a tax holiday would. The certainty of a 35% tax isn’t nearly as much of an obstruction to shareholder value creation as allowing corporations another excuse to accumulate capital they don’t know how to allocate.

It’s not the government’s job to create shareholder value. Nor is it the board’s job to play “wait and see” with U.S. taxing authorities. Let’s put that responsibility where it belongs. The board works for the shareholder and makes sure value is created. That corporate America’s boards and managements frequently have the nerve to sell tax engineering to shareholders as shareholder value preservation – or tax holidays as “job growth” engines – only adds insult to injury. It also provides even more unwanted, unnecessary distractions from the real business at hand.

Let Microsoft lead the way in the fight to end all this nonsense. Let’s bring the cash home, pay the taxes, and distribute the profits to shareholders via dividends and share repurchases. Let’s stop being mesmerized by tax engineering and the fantasy that the government will save us from paying taxes… And let’s get back to creating value and running one of the greatest businesses in the world for the benefit of its owners.

So ladies and gentlemen of the board, I implore you not to sit waiting to see if and when a tax holiday might arrive. Microsoft didn’t wait for the government to tell it to create Windows 7, the best-selling operating system in history. It didn’t wait for the government to tell it to revolutionize the Windows platform with Windows 8. It didn’t wait for the government to tell it to make Surface, the first Microsoft-manufactured tablet.

Likewise, Expeditors’ board doesn’t wait for the government to tell it what to do with its money. Microsoft shouldn’t wait, either. When a public company has excess capital sitting idle on the balance sheet, there is only one solution to the problem: return it to the owners of the company. Given the enormous amount of capital involved (enough equity to capitalize another Microsoft-sized business), it looks like having too much idle capital on hand has become a chronic problem for Microsoft. To this end, I believe Microsoft should take two radical actions immediately:

1) Microsoft should increase the amount of its per-share dividend by at least 50%.

2) Microsoft should bring foreign cash holdings back to the U.S. and immediately undertake a large share repurchase program as long as the stock trades at or below an enterprise value of 15 times free cash flow. At that price, share repurchases would create enormous value for existing shareholders.

For the fiscal year ending June 30, Microsoft generated over $29 billion of free cash flow. It paid out $11.4 billion in dividends and share repurchases. During the year, Microsoft’s cash and investments balance increased by about $10.6 billion. That’s another $10.6 billion in cash, sitting idle.

Microsoft paid out $6.4 billion in cash dividends last year. It could have paid out triple that amount. From that perspective, the immediate 50% dividend hike I propose seems a modest initial change, one that should easily meet with board approval.

Subsequent changes to ongoing capital allocation policy are necessary to ensure Microsoft shareholders are rewarded in a manner commensurate with the enormous business success its management has created and continues to create. I believe the following policies should be instituted as soon as possible:

  • Target at least 60% of free cash flows paid out in dividends.
  • Repurchase shares with available excess cash at a price not to exceed an enterprise value per share of 15 times free cash flow.
  • Bring all excess foreign-earned cash home to the U.S., for distribution to shareholders via dividends or share repurchases.

Taking the above actions makes a higher market valuation for Microsoft shares a virtual certainty. If Microsoft raised its dividend by 50% immediately, and instituted a policy of paying out 60% of its free cash flow as dividends, a 40% rise in the share price wouldn’t be an unreasonable expectation.

Investors are starved for safe, growing incomes now more than ever, which has pushed up the share price of fellow blue-chip dividend-payers Wal-Mart (NYSE: WMT) and Johnson & Johnson (NYSE: JNJ). Microsoft has already developed a reputation as a good blue-chip dividend-growth stock. A renewed commitment to rewarding shareholders with a much higher dividend should be more than welcomed by many investors.

As I write this letter, Microsoft’s shares are trading just below $30. A 50% rise in the dividend could easily catapult the share price into the mid-$40s, where it belongs.

The S&P 500 trades around 16 times earnings. Microsoft trades around 11 times earnings, adjusted for excess cash. Microsoft is a far better company than most members of the S&P 500. It should trade at a premium to the market, not a discount. The actions I proposed should help correct that discrepancy.

Most businesses envy Microsoft’s success. Few envy its depressed valuation. I hope you’ll address the latter and make Microsoft the envy of every public company in the world.

Thank you, ladies and gentlemen of the board, for considering my ideas.


Dan Ferris
Microsoft shareholder


Source: Extreme Value