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Why is Microsoft Buying Back $40 Billion of its Own Stock?

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Daniel Eran Dilger.
Warren Buffett outlined one reason why Microsoft is spending another $40 billion buying back its stock over the next half decade (and why HP is also spending $8 billion to buy back its own stock). I’ll outline another.
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Warren Buffett on Rewarding Failure.

In a 2005 letter to shareholders of Berkshire Hathaway, Warren Buffett wrote:

Too often, executive compensation in the U.S. is ridiculously out of line with performance. That won’t change, moreover, because the deck is stacked against investors when it comes to the CEO’s pay. The upshot is that a mediocre-or-worse CEO – aided by his handpicked VP of human relations and a consultant from the ever-accommodating firm of Ratchet, Ratchet and Bingo – all too often receives gobs of money from an ill-designed compensation arrangement.

Take, for instance, ten year, fixed-price options (and who wouldn’t?). If Fred Futile, CEO of Stagnant, Inc., receives a bundle of these – let’s say enough to give him an option on 1% of the company – his self-interest is clear: He should skip dividends entirely and instead use all of the company’s earnings to repurchase stock.

[...]

Getting fired can produce a particularly bountiful payday for a CEO. Indeed, he can “earn” more in that single day, while cleaning out his desk, than an American worker earns in a lifetime of cleaning toilets. Forget the old maxim about nothing succeeding like success: Today, in the executive suite, the all-too-prevalent rule is that nothing succeeds like failure.

http://www.berkshirehathaway.com/letters/2005ltr.pdf

And from a blog post by J. K. Wilson:

“In a nutshell, stock repurchases or ‘buybacks’ are just a way for corporations to pay executives and other employees at the stockholder’s expense.

Hodar Market Report: What stock buybacks actually accomplish

Admitting Failure.

Spending your capital to buy back stock also indicates that you have no ideas for using that capital to build your business, and are instead converting it into value for shareholders, including executives and employees holding options (the opposite of diluting your stock by creating new shares).

Essentially, Microsoft is doing what Dell thought Apple should have done ten years ago: shut things down and give the money back to shareholders.

If Microsoft had any implementable ideas, it would be using that $40 billion to make more money, just like Apple has used its capital to rapidly expand its business while earning more cash on hand. Apple isn’t buying back its stock because it thinks it can make more for investors building new business than it can by simply giving the money back.

But Microsoft Still Has Market Share!

Critics who can find no problems with Microsoft’s record earnings and its dominance of Gartner’s market share reports have fallen for the market share myth. Linux, Apple and Microsoft aren’t companies selling competing widgets. Apple sells PCs that don’t have Microsoft’s OEM software on them, while Linux is used as an alternative to Microsoft’s software. Rather than directly competing for ”sales,“ Apple and Linux both serve to compete with Microsoft for attention (development) and air supply.

Comparing ”market share,“ particularly when talking about Linux, which isn’t even sold, is absurd. One might as well be describing a man in a sealed room with a fire burning in one corner as safe because the fire only consumes a very small portion of the the room’s ”cubic inch share.“ The real problem is that it is eating up the room’s oxygen and putting out toxins.

Microsoft has worked well with a monopoly over the PC OS and software markets. But with competition from non-Windows PCs (both Macs and Acer/Dells running Linux) and from alternative server software (open source servers, which power more web servers than Windows Server), Microsoft is now finding its air supply getting cut off while its proprietary business model is poisoned by the insidiously opportunistic spread of open source. That’s why Microsoft calls it a ”cancer.“

Microsoft’s Unwinnable War on Linux and Open Source

The Beginning of the End.

Microsoft is still making loads of money, but Windows has hit a brick wall with Vista, its consumer products have all tanked and are losing loads of money, and competition is just barely getting started.

Apple is growing 10x faster than the PC market in general, and the top PC makers (HP, Dell, Acer) are all actively working to find new ways to use Linux or develop their own OS in imitation of Apple. Even if Windows 7 turned out to be a good product in 2010, it wouldn’t matter, because nobody wants to pay for a PC OS anymore.

Microsoft is fundamentally screwed. The worst part is that it is not taking any effective stabs at building a new model or innovating itself out of crisis. Shifts happen all the time. If big companies can’t adapt, they die, and Microsoft isn’t proving it can adapt. It’s merely reacting with stock buybacks and imitative advertising (including its $300 million ads that primarily draw attention to Apple’s brand.)

 Wp-Content Uploads 2008 09 200809202345

Microsoft’s ”I’m a PC“ Millions Actually Promoting the Mac
Imagine Steve Jobs for President

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22 comments

1 Realtosh { 09.24.08 at 12:49 am }

An Apple IBM alliance for delivering Macs to all business service customers of IBM’s would be the type of game-changing event that would get this ball rolling.

I wonder how much loyalty $300M will buy, when everyone is running in new directions.

2 dreil { 09.24.08 at 12:49 am }

I would like to take this moment to point out that MSFT is also paying a dividend, which is being increased. I do agree with the fact that buying back stock instead of buying things is silly, but please, do get your facts straight.

3 rudiger { 09.24.08 at 1:11 am }

You say Microsoft is fundamentally screwed, but I think it’s your views that are fundamentally skewed.

Apple good! Microsoft bad!

Baa! Baaaaa~! *the sound of sheep bleating*

4 Realtosh { 09.24.08 at 1:17 am }

$40 Billion spent buying back stock is quite giving the money to shareholders.

It is cashing out individual stockholders. It is concentrating the stake of remaining shareholders, and others with interests in the company, especially the the executives who have options for certain numbers of stocks.

I’m going to read Warren Buffet’s example above, right after I finish this comment. If a company buys back half of all stock outstanding, then the stock options held by executives will double the interest in the company for each executive. For example, if an executive has a fixed number of options equal to 1% of a company, then buying back half of the outstanding shares of the company will have this stake equal approximately 2%. An executive or executive team that own(s) a fixed number of options equal to 5% of the company would see their stake double to about 10%, and so on. A 20% stake in options would likewise double to about 40%. (I didn’t account for the dilutive effect that exercising the options would have on total shares outstanding.)

The way to return the cash to shareholders would be through paying dividends to stockholders. With dividend reinvestment provisions in most corporations, much of this money would end up invested back in the company. However, this newly invested money would have a potentially dilutive effect on shares of additional shares need to be issued to accommodate the repurchase of shares through dividend reinvestment provisions.

Stock buybacks increase executive ownership of company. Dividend payments can dilute executive stake. These financials principles would apply to all remaining stockholders, including all that have options whether they are in the executive offices or whether they are on the board. Both execs and board members get stock options at many companies today. Stock buybacks amplify the value of the options held by both groups, at the expense of shareholders.

5 Realtosh { 09.24.08 at 1:19 am }

$40 Billion spent buying back stock is NOT quite giving the money to shareholders.

Left out one important word. Sorry.

6 celeduc { 09.24.08 at 1:56 am }

Excellent analysis, Daniel.

7 John E { 09.24.08 at 2:36 am }

well, there is a bit more to it …

back in the day, corporations actually prioritized paying dividends. that was when the price/earnings ratio of a stock meant something real. but somewhere in the 80′s the stock market turned into a speculative market instead keyed to future “expectations.” so it only matters can i find someone to pay more than i did? never mind last year’s financials. the extreme of that mentality was the dot.com bubble.

so corporations like MS – and Apple – pile up cash. MS stock has been flat for years now, meaning the market speculator’s expectations of its future are flat too. buying back stock is one tactic to counter that and bump up the price. sure it’s good for the insiders, but it’s good for the stock owners too. it’s better business than letting the cash sit in a bank.

Dan forgot to mention MS did try to spend most of the cash first – to buy Yahoo. didn’t happen. MS has an unusual problem – buying any other large software or web services company would raise antitrust issues, especially with the Europeans who are much more vigilent. so unless MS wants to go into hardware bigtime – and it doesn’t – it has no place to spend all that dough. so if i were in their shoes, i’d do the same thing (and they are increasing the dividends as well).

Apple is sitting on its pile of cash too – over $20 billion. so why not criticize Apple as well? except for a media store the are no antitrust issues. but Apple has never used acquisitions to expand into markets, only instead to acquire new technology. that’s smart, but only uses a small fraction of that cash hoard.

and for hardware, except for the iPhone/Touch there have been no major new product lines introduced at big scale in the last few years. MacBook Air is a niche product for the well-off when the world really needs a $500 iTablet much more – but Jobs apparently won’t risk a $billion on it. both AppleTV and MobileMe clearly need more substance, but Jobs keeps holding back big investment there too.

nonetheless Apple’s stock price has gone up, which means speculative expectations for its future are high, so a stock buy-back is unnecessary, even for Apple insiders.

Come’on Steve, spend some on those $billions on killer new products!

8 Jesse { 09.24.08 at 3:07 am }

iTablet, feh. The Mac line-up is intended to be extremely, extremely simple, with the intention being that within the first five minutes in the store you know which product you want, and most of the time you can tell before you even look at the specs. Not only would the feature set of a tablet muddy the clearly defined product lines, the form factor would as well. It’s a product that’s vaguely targeted at best. And the Windows versions haven’t made the case that there’s market demand anyway.

Feh, I say, feh.

9 John E { 09.24.08 at 4:25 am }

yeah, so how would you have Apple use its $20 billion? let’s hear a better idea than “feh.”

10 roz { 09.24.08 at 5:03 am }

how about $200 M for a device that would allow the AppleTV to act like an HD tivo/slingbox.

11 lmasanti { 09.24.08 at 9:33 am }

quote:
“…but Windows has hit a brick wall with Vista,…”

Now I do understand the last ad about “walls and windows…”

12 Realtosh { 09.24.08 at 9:36 am }

@ dreil

No one ever said Microsoft doesn’t have a dividend. In fact Microsoft pays 11¢ per share quarterly. Oooo wow 11¢. That’s just $1B per quarter.

On the other hand Microsoft just completed a $40 Billion round of stock buybacks. They just announced another round of stock buy backs for another $40 Billion.

The main point is that Microsoft has nothing good to do with their piles of money. So they have to get rid of it through dividends and stock buybacks.

Microsoft needed to get rid of their freakishly large accumulation of cash. The money just reinforces the perception that they have a monopoly and are just raping and pillaging their partners in the computer industry, that struggle for profits. It is not a stretch to say that Microsoft’s monopoly not only strangles much innovation and creativity in their own ecosystem, since they are bleeding out the fattest layer of profits. So it it fairly easy to posit that this money ultimately comes from the consumers, who pay more and get less.

That’s why you’re seeing movement away from Microsoft, and toward the only other viable option at the moment, Apple.

13 Realtosh { 09.24.08 at 10:09 am }

@ John E
“Apple is sitting on its pile of cash too – over $20 billion. so why not criticize Apple as well? ”

For one, Apple shows that they know what to do with capital. They are successfully growing their business organically at the envy of many competitors who just aren’t firing on all cylinders like Apple.

Second, the Apple executive team has said that they are retaining their earning for strategic purposes. Apple also regularly buys up small companies, whose technologies and personnel are useful to Apple’s businesses. Apple also reserves the opportunity to make a large game changing acquisition, if and when the right opportunity arises.

Third, Apple uses their money to finance buying binges of components for their key products. They prepay in exchange for favorable terms. They get better pricing, earlier delivery, guaranteed stock even when inventory is tight for a particular component. Apple gets better terms and amazing deals on components, much better than their competitors. That’s another god use of their capital.

Apple is growing at an accelerated pace, and have long ago overgrown their campus in Cupertino. Another large Apple project is building another campus in Cupertino to accommodate their growing staff. Acquisition of land and paying for construction is another use of their cash on hand.

So it’s quite clear that Apple is using their capital quite nicely.

Even so, Apple is still accumulating cash quickly, so years ago they set up a subsidiary, Braeburn Capital, an asset management company based in Reno, to manage their cash and investments. They even moved that subsidiary out of California to avoid additional taxes, that reduce their returns on their capital. Nevada offers a better taxing regime and is attracting investment that otherwise would have gone to California and other states with less attractive taxing regimes..

14 fatbarstard { 09.24.08 at 12:11 pm }

Ahhh… Corporate Finance… something I DO know something about… I couldn’t programme my way out of a wet paper bag, but this I do know.

Buffet is perhaps presenting a more extreme view of share buy-backs but it is generally accepted that companies buy back shares for two reasons… Firstly, they decide that they can’t do anything with the money and the cash is weighing down the balance sheet – in other words the return on capital is low because cash is a pretty unproductive asset (earns 3% -4% interest?). Or the company is under geared, so they give the cash back to shareholders and take on debt to get a better over capital structure – this sort of thing does create value for shareholders when don right.

It doesn’t necessarily mean that they can’t do anything useful with the cash, but that is sometimes the case. more the point, a company should return cash to shareholders if it can’t find a use for it – after all it is the shareholders money.

The second reason is that the company thinks its stock is undervalued in the market place – by reducing the number of shares on issue, via repurchasing shares, the earnings per share rises and by implication so does the share price – so each remaining share is more valuable, because it represents a greater share of the total value of the company.

Now where I come from share buy backs come in two forms; mandatory and voluntary. in a mandatory buyback every shareholder gets cash whether they like it or not. Often a company will do a mandatory buy back if they are returning ‘capital’ rather than accumulated surpluses, because returning capital is tax free, whereas returning accumulated surpluses may be taxed. if the buyback is voluntary then the company will ask a broker to buy back shares more or less every day on its behalf, so if you want to participate you sell your shares on the market.

Now on the question of dividends. Dividends are a distribution of current year earnings, whereas a buyback is either a distribution of capital and/or of prior year earnings that have been retained. So the two are linked, but they are not the same thing. A company can merrily pay dividends and never have a buyback programme.

In MSFT’s case I suspect the buyback is part of a wider capital management programme – knowing Chris Liddell as I do (our kids used to play in the same soccer team at Maddills Farm in Auckland, New Zealand) the focus will be on wider capital management issues rather than giving it back because they don’t know what to do with it.

15 John E { 09.24.08 at 1:42 pm }

@realtosh

yes, Apple does those prudent things with its cash. but still all together they only use a fraction of the $20 billion. basically Apple is sitting on the rest, however it is invested in Nevada. that is not productive, and it is not moving technology forward.

16 John Muir { 09.24.08 at 2:26 pm }

@ fatbarstard

Thanks for the explanation. I’m the kind of stocks n00b who thinks companies should just reinvest whatever they can in expanding and diversifying their business, although it’s certainly correct that not all companies are Apple and such things aren’t so easy for them to do.

@ John E

On a similar point: with recession very much on the horizon now, and the ongoing shift to lowest common denominator production based in China, who wouldn’t want to have the breathing space Apple has with that cash in hand?

There’s a credit crunch: and Apple has lots of credit. Sounds pretty smart to me. ;)

17 Realtosh { 09.24.08 at 3:05 pm }

@ fatbarstard

Nice financial explanation.

I have no doubt that the buybacks and dividends are part of wider capital management issues.

Don’t get lost in the difference proximate and ultimate causality. Ultimately these strategies are part of Microsoft’s overall capital management plan because Microsoft’s management has no better use for the funds, so they’re returning them to shareholders.

I think it was appropriate for Dan to bring up the fact the Microsoft and many other companies’ management seem to favoring buybacks more than dividends.

Buffet is right in pointing out that these techniques may be favored by management at many companies, at the expense of regular shareholders. By concentrating a the value of the company in fewer shares, the stake held by management becomes a larger proportion of the total value of the company. Greater part of the company for management means less company for all other shareholders. Buffet tells us, “CEOs understand this math and know that every dime paid out in dividends reduces the value of all outstanding options,” and “Indeed, the very thought of options with strike prices that are adjusted for retained earnings seems foreign to compensation ‘experts,’ who are nevertheless encyclopedic about every management-friendly plan that exists.”

It is fair game to point out these financial strategies that are beneficial to management at the expense of ordinary shareholders. By contrast, Apple use of capital increases the value of Apple’s operations and of their capital on hand. Both of those increase value to all shareholders.

Another important issue that I meant to mention earlier, but no one has yet talked about is all those shares held by current and former employees of Microsoft.

As Microsoft was growing wildly, the share price kept going up. All these employees became millionaires just from the options.

Now that Microsoft has a stable mature business, with little hope of outsize growth, it’s share price has been stagnant for years. what does that have to do with employees. A lot of those folks that stuck around as they were amassing a small fortune, aren’t as motivated now that that their shares are growing in value. Plus there are opportunities aplenty for them to try to take their Microsoft resume and jump into startups are smaller companies where they can try to ride another wave.

So when these folks take off for their new adventures, many if not most will sell a significant portion or all of the Microsoft holdings. They either need the capital to live, as they start over, to buy into the new entity, or to break their financial ties to a company for which they no longer have any role in.

Over the years, there have been many Microsoft folks who have left for greener pastures. As all those stocks flood onto the open market, it could have the paradoxical effect of dampening the value of the Microsoft stock.

Microsoft may need a stock buy back just to soak up much of this stock that was never purchased in the first place, but was merely a part of a compensation package from a company they no longer work for.

Plus there are many investors, who rode the Microsoft wave on the way up, and don’t see much point in sticking with a stock that no longer has explosive growth, that doesn’t have many prospects for explosive growth and that is only paying 11¢ per share in quarterly dividends. Many investors are figuring correctly, “What’s in it for me?”

18 Realtosh { 09.24.08 at 3:14 pm }

@ John Muir

ditto

Apple’s in a nice place right now.

With the kind of credit crunch we’re experiencing, it’s pretty good to have more cash on hand than the Wall Street bankers, who are normally the ones to issue the corporate paper to raise the funds. The commercial paper market has been greatly restricted by all the financial turmoil we’ve been experiencing most of this year.

Apple doesn’t have to worry about any of that. They can start any project they want and that is productive for shareholder value knowing that they can guarantee production and have the bank to pay for it in advance. Sure make things easier for Apple when everyone else is worrying about the credit markets.

19 Realtosh { 09.24.08 at 3:32 pm }

@ John E

By definition the $20m is what’s left over after they pay for operations, so they are not really using most of it at all. That money is their piggybank. They keep the capital in-house at Braeburn Capital, instead of giving it to an investment house to manage.

Most of that money just sits there for strategic purposes. They can dip into if necessary to make huge prepayment for components, buy and build their campus, and make strategic acquisitions.

They also have money on hand to battle Microsoft if necessary, and also to keep Microsoft from even trying an expensive attack against Apple to deplete Apple’s resources and either put them out of business or make them a weak competitor. The funds are also nice in that it keeps others from even thinking about acquiring Apple, because it get more expensive. This way Apple’s management can concentrate on their business, not having to worry about corporate raiders. In contrast the money is there for Apple to use to acquire others strategically.

So apart from operations and capital expenditures, Apple’s bank gives them a lot of strategic power.

I don’t worry so much about Apple management retaining earnings because they have a track record that shows that they know how to use capital efficiently and effectively.

I can’t say the same thing for Microsoft. Microsoft brings in lots of free cash from their monopoly businesses, and wastes $Billions trying in vain to establish other monopolistic platforms. Luckily for all of us, but unfortunately for MSFT shareholders, they have been unsuccessful in these attempts to extend their control of other industries.

As for Apple, let them save up their money. Some day they will use it to grow into new directions. Just wait and see.

20 John E { 09.25.08 at 12:55 am }

been waiting to see for several years now, but ain’t nothing much happened – except iPhone – yet.

i mean, spend what it takes to make AppleTV and MobileMe really outstanding products, or give them up, you know?

21 majipoor { 09.25.08 at 5:03 am }

Apple was a PC company. During the last few years, starting with iPod/iTunes, Apple enter the music hardware and distribution market with some success. Recently, then enter the movie hardware and distribution market with AppleTV/iTunes Movie Store. And now, they enter the phone / mobile market with the iPhone.

I think that it may be too early to put too much effort in AppleTV hardware until distribution channel are more developed: they need content and not only hardware.

And concerning cash, it appears that Apple mostly develop its markets with new ideas and concepts which doesn’t cost that much. Apple do not need cash right now.

I remember just a few years ago when Steve Jobs tell that Apple should become a $10b / year company next year. Apple is now a $30b / year company with only 5% market share in computer and a less than 1% market share in mobile industry. There is PLENTY of room for a tremendous growth for Apple without having to spend their cash.

22 Boycott Novell » Eye on Microsoft: Assortment of Key Observations { 09.25.08 at 10:08 am }

[...] have already expressed our views on the Microsoft buybacks. Roughly Drafted has some more ideas. Spending your capital to buy back stock also indicates that you have no ideas for using that [...]

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