Shares of Microsoft (NASDAQ: MSFT) surged yesterday after news leaked that the company will raise debt in order to pay out a dividend to shareholders. While Microsoft does hold $36.8 billion in cash, much of that money is being held overseas and would be subject to repatriation taxes upon using that cash to payout dividends in the US.
The company plans to use its AAA rating in order to raise as much money as possible for the effort. Some estimate they could raise as much as $6 billion. Microsoft is clearly taking advantage of the low interest rate environment and the quest for yield from investors.
Why is this significant?
This weekend, two themes featured prominently in my reading: first was the idea that younger generations were spurning equities, second was the notion that Tech Stocks had fallen out of favor due to their large cash hoards coupled with diminishing equity returns. Barron’s had two articles dedicated specifically to this issue. The lead tech article from Barron’s stated bluntly that “The refusal of tech companies to offer dividends could be hurting their share prices by keeping income-oriented investors away.”
Many of the largest Tech companies hold over 15% of their market caps as cash, with predominantly paltry yields. A recent research note from Bernstein tech analyst, Toni Sacconaghi, pointed out that “only 10 of the top 20 tech companies pay a dividend, and just two- Intel and ADP – pay a dividend above the S&P 500 yield.” Sacconaghi asserted that the lack of cash returns to shareholders, coupled with slowing growth and tech companies reporting earnings in non-GAAP has led Technology as a sector to trade at multi-decade lows in valuation relative to the S&P.
These big cap tech companies generate substantial free cash-flows; however, it is problematic in terms of paying out dividends that much of the cash comes from overseas. This makes it costly to repatriate the cash in order to use it for dividends and buybacks. With talk of a “bond bubble” and exceptionally low interest rates, it makes sense for the some companies to tap into debt markets in order to generate a return for their equity shareholders.
Microsoft’s impending move is an explicit acknowledgment by the company that more needs to be done in order to both appease existing shareholders and attract new shareholders in a time at which the 10-year Treasuries are yielding barely more than 2.5% and money markets yielding next to nothing, the chase for yield is tantamount.
This type of action is far more constructive than engaging each other in bidding wars in grasping for new growth. Often times, the winner of such a war is plagued by the “winner’s curse.” In arguing that Hewlett-Packard (NYSE: HPQ) may fall victim to such a curse after purchasing 3Par (NYSE: PAR), Wade Slome described the paradox as follows:
In bidding wars and auctions, the victor of the price battle runs the risk of earning the “Winner’s Curse.” The curse falls upon those that bid a price that exceeds an auctioned asset’s intrinsic value. How can this occur? Well for one reason, the bidder may not have complete information regarding the value of the asset. Secondly, there can be emotional factors, or ego, that play a role in the decision and price paid. Lastly, unique factors, such as strategic benefits or synergies may exist that allow one bidder to offer a higher price than other auction participants.
Whereas HP has taken a severe beating since engaging in a bidding with Dell (NASDAQ: DELL), Microsoft’s stock surged on the news of the debt-raise for dividend. Granted, the initial reaction means little in the long run and HP has also suffered from former CEO Mark Hurd’s sudden and dramatic departure. However, with such substantial cash positions on balance sheets, tech companies have the ammo necessary to generate outsized returns for their investors.
What this means moving forward:
As the weekend drew to a close, I started thinking to myself that “the next leg up in this market will be driven by the Tech Sector making use of their cash.”
The news out of Microsoft was a timely affirmation of this hypothesis. It shows that management at Tech companies are cognizant of the concerns expressed by analysts and shareholders over the lack of yield, and that the companies are willing to get creative in this environment in order to generate better returns for their shareholders. On average, the big technology companies trade with a p/e multiple of 11.7, lower than that of the Telecom and Utilities sectors. Generally it takes a bold first actor to get the rest to fall in line. I expect nothing less in this environment.
Technology as a sector, as indicated by the XLK ETF, bottomed before the broader markets in November of 2008. However, since the broader bottom in March of 2009, it has performed in-line with the S&P 500, despite Apple (NASDAQ: AAPL) now accounting for 10+% of the index while rallying over 200% in that time. Whereas Tech typically leads in Bull markets, it has yet to do so since the 2009 lows. A move to appease the investor appetite for yield would go tremendous lengths towards boosting valuations in the sector. Should this sector once again attract a new wave investors, then the market’s will have the catalyst it needs to drive upward out of this multi-month trading range.
Disclosure: No relevant positions in stocks mentioned in this article.