What is Microsoft Corporation (NASDAQ:MSFT) CEO Satya Nadella’s most important job? If you answered building long-term value in MSFT stock, you’d be correct, but only partially.
That’s because many investors wrongly equate value with short-term price movements — not what happens over a decade or more.
Warren Buffett isn’t called the Oracle of Omaha because he guessed correctly that one of his billion-dollar holdings would go up in value over a six-month period. He’s considered an investment genius because Berkshire Hathaway Inc. (NYSE:BRK.A, NYSE:BRK.B) stock has generated an overall gain of 1,598,284% over the past 51 years. He, better than almost anyone on this planet, understands the importance of building long-term value. It’s this skill that makes him such a great CEO.
So, how does Nadella build long-term value in MSFT stock? He allocates Microsoft’s capital in an effective manner. That’s his most important task as CEO. Everything else is secondary.
Capital is generated from four sources: operations, asset sales and the issuance of equity and debt. Nadella has seven alternatives for allocating this capital: capital expenditures, working capital, acquisitions, R&D, dividends, share buybacks and debt repayment.
In this article, I’ll specifically focus on Microsoft’s use of debt including the repayment of that debt. With borrowing costs at all-time lows, it’s only natural that companies are taking advantage of this capital source to then utilize one or more of the capital allocation levers mentioned above.
Microsoft’s Debt
While it would be nice to generate all your capital allocation needs internally, that’s not always possible. Nor is it always prudent.
Up until Microsoft’s 2009 fiscal year (June 30, 2009) it had no debt, short-term or long-term. At the time, MSFT opted to issue debt given it was one of just a few companies with an AAA credit rating. People are always willing to lend you money when you don’t need it.
In 2009, Microsoft issued $2 billion in short-term commercial paper with maturities ranging from 22 to 119 days. In addition, it finished the fiscal year with an undrawn $1 billion 364-day credit facility. That same year, Microsoft stock issued $3.75 billion in long-term debt — $2 billion in 2.95% notes due June 1, 2014; $1 billion in 4.20% notes due June 1, 2019; and, 5.20% notes due June 1, 2039 — bringing its total debt outstanding to $5.75 billion.
Today, Microsoft’s debt situation is much different.
MSFT recently sold bonds worth $19.75 billion at interest rates between 1.1% and 3.95% to fund its $26.2 billion acquisition of LinkedIn Corporation (NYSE:LNKD) — a deal Nadella rationalized as one that would combine LinkedIn’s huge professional network with Microsoft’s professional cloud offerings.
If you include this new debt with existing short-term and long-term obligations, Microsoft’s total debt is now $73.3 billion. LinkedIn’s total assets as of the second quarter were $7.3 billion. Those get added to Microsoft’s balance sheet along with $18.9 billion in goodwill. Subtract $6.45 billion in cash from MSFT’s balance sheet (used to top-up acquisition payment) and you have pro forma total assets of $213.5 billion.
Getting back to Microsoft’s debt: When it first issued bonds back in 2009, its total debt to assets was 7.4%; after the LinkedIn deal, it will be 34.3%, an increase of almost four-fold.
One-third debt, two-thirds equity isn’t a problem for a company that generates almost $25 billion annually in free cash flow. However, it is important to understand that Microsoft’s capital structure has changed in a material way in less than a decade.
Microsoft’s Debt Repayment
One mustn’t lose track of Microsoft’s debt repayment. If MSFT continues to pay out $11 billion in dividends per year along with $16 billion in share repurchases and it simultaneously is unable to figure out how to make LinkedIn profitable, or at least profit from its network, Microsoft’s $100 billion-plus in cash is going to disappear pretty quickly.
Something is going to have to give. MSFT has three options:
- It issues equity to raise cash for debt repayment. That’s a non-starter. Diluting shareholders when you already have the cash for debt repayment makes little sense.
- It whittles down its cash horde to pay down debt while keeping all other capital allocation levers business as usual.
- It stops buying back MSFT stock for three to five years until debt levels are down below 20% of total assets.
Cutting R&D, working capital or capital expenditures are all off the table because it’s these three that keep the business growing organically. As for further M&A, that’s still doable but best left alone unless the acquisition is immediately accretive to earnings or can be done with stock.
In fiscal 2016, Microsoft repaid $2.8 billion in debt. That’s just 3.8% of its new debt load. If it keeps up this pace of debt repayment given Microsoft’s rate of growth, it’s going to take at least 15 to 20 years to pay down the debt, and that’s being conservative.
How does Microsoft rate on debt repayment?
Not well.
Bottom Line on MSFT
The LinkedIn deal has ratcheted up its debt by almost 40% in the span of a few months with no apparent signs of a debt repayment plan.
CEO Satya Nadella had better get one quick. Those interest payments, albeit at pretty sweet rates, aren’t going away anytime soon.
As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.
