Friday, July 21, 2006

Microsoft Buyback: Should You Bite?

News Analysis
July 21, 2006

Business Week Online

Microsoft Buyback: Should You Bite?

The software giant wants to repurchase up to $20 billion of its shares by Aug. 17. Here's why investors may want to take the offer

Wall Street cheered on July 21 after Microsoft (MSFT ) unveiled a plan to buy back up to $20 billion of its shares next month. Shares of the Redmond (Wash.) software behemoth surged 4.5% to $23.87 at the close of trading July 21, the session following the announcement. Over the next five years, the repurchase program could total $40 billion (see, 7/21/06, "Microsoft's New, Improved Spending").

Microsoft stock's sudden popularity may prove short-lived. Adjusted for splits, the shares have drifted between $20 and $30 for more than four years (see, 6/19/06, "More of the Same for Microsoft Stock?"). Now that the price is up on the latest news, it could be as good a time as any for impatient shareholders to give Microsoft CEO Steve Ballmer his stock back. But Redmond's big move leaves few clear winners—particularly not those who bought the stock anywhere near the peak it reached nearly seven years ago, when it soared as high as a split-adjusted $51.80.

The current $20 billion tender offer calls for Microsoft to buy back as many as 808 million shares, or 8.1% of its outstanding stock, in a reverse Dutch auction. Shareholders can tender their stocks from July 21 through Aug. 17. They can choose the number of stocks they wish to sell and a price between $22.50 and $24.75 a share.

Companies and investors favor buybacks because they reduce the number of shares outstanding, which improves earnings per share. Buybacks also absorb the excess stock created when employees exercise stock options.

THROUGH ANALYSTS' EYES.  Microsoft's repurchase program, revealed alongside a 24% drop in quarterly earnings, comes after shareholders have chastised the software maker for failing to fire up its flagging share price. In April, Microsoft announced bigger-than-expected spending on new investments, and investors sent shares down 11% in one day (see, 4/28/06, "Microsoft's Strange Spending Splurge"). On the heels of a $30 billion buyback over two years, the company is now putting its hefty cash pile—$34.2 billion as of June 30—to the use the Street wanted.

It might not be enough to provide a sustained lift to the shares. While analysts remain mixed on the stock, most don't see the buyback fundamentally altering the challenges Microsoft faces as it transitions from its familiar PC-based model toward faster-growing market segments. The company forecasts $500 million in investments in online services next year, which analysts say could keep it from improving its margins.

Indeed, Microsoft stock may have gotten the bulk of its buyback-related boost even before the July 21 opening bell, some analysts say. "Upside from $20 billion tender offer [is] already in stock pre-open," Merrill Lynch analyst Kash Rangan wrote in a July 21 report. Rangan, who has a neutral recommendation on the stock, also notes that the tender offer probably rules out a major acquisition such as Yahoo! (YHOO ) or eBay (EBAY ) for roughly the next year. (Merrill has an investment banking relationship with Microsoft and makes a market in its securities.)

THE CASE FOR SELLING.  If Microsoft shares break out of their recent rut, it might not happen until fiscal 2008, according to Rangan. The company's online business probably won't become profitable before then, though Microsoft projects 7% to 11% fiscal 2007 growth in this area, which includes services like adCenter, Office Live, and Search. Reaching this milestone could drive the stock higher, Rangan says.

Margins at Microsoft are in a "tailspin," says Citigroup analyst Brent Thill, who has a hold recommendation on the stock. Thill guided his fiscal 2007 operating-margin estimate down from 39% to 35.6% after the announcement, noting that investors had hoped for operating leverage from the new Vista operating system. "Microsoft thinks their stock is cheap, but we think declining operating margins do not warrant significant share appreciation," Thill wrote in a July 21 note to clients. (Citigroup owns 5% or more of a class of Microsoft securities.)

Meanwhile, other tech stocks may offer bigger upside. Credit Suisse analyst Jason Maynard sees superior growth chances in Red Hat (RHAT ), (CRM ), Google (GOOG ), and Yahoo, plus a better large-cap opportunity in Oracle (ORCL ) because of its exposure to corporate spending. Open-source software, on-demand computing, and advertising-based business models could all cut into Microsoft's revenue, Maynard wrote in a July 21 report. He has a neutral recommendation on the stock. (Credit Suisse has an investment banking relationship with Microsoft and makes a market in its securities.)

REASONS TO STAY.  Still, Microsoft stock has its fans. Morningstar analyst Toan Tran estimates the stock's fair value at $34, hailing the buyback as a smart move to shore up the company's capital structure. "Microsoft is prudently investing to ensure that there are many more chapters ahead for the world's largest software company," Tran wrote in a July 21 report.

Tran says another reason to hang onto the software maker's shares is the pending launch of its new products, including the long-awaited arrival of Vista. On July 21, Microsoft confirmed it would also introduce music hardware and software to compete with Apple's (AAPL ) iPod and iTunes. In 2005, Microsoft rolled out the Xbox 360. The company expects to have shipped as many as 15 million of the video-game consoles by June 30, 2007, amid anticipated competition from Sony's (SNE ) PlayStation 3.

Microsoft's server business is an additional bright spot. The servers and tools segment reported 18% fiscal fourth-quarter growth vs. the same period a year earlier, at the high end of guidance, and should continue to build momentum in the rest of the calendar year, observes UBS analyst Heather Bellini, who rates the stock a buy. (UBS has an investment banking relationship with Microsoft and makes a market in its securities.)

WHICH INVESTORS BENEFIT?  But the stock continues to languish despite the company's successes. Indeed, one factor that may give pause to both sellers and Microsoft's stock price is a lack of upside. The tender offer's $22.50 to $24.75 price range means only an 8% return on the high end, which means the buyback may not get full subscription, notes Merill's Rangan. The remaining $20 billion repurchase through 2011 would likely be more gradual and therefore give the stock a less dramatic jolt.

Further, it's unclear how many investors will really gain at that price. The offer only makes sense for investors who bought the stock before 1999, investors who bought it in the past two months, and those who bought in the intervening years and don't mind taking a loss to reduce their exposure, says Citigroup's Thill.

Microsoft's buyback bid may not make investors rich by Aug. 17 or in the months afterward. But for shareholders seeking an exit strategy after years of stagnant stock prices, it's a chance to reboot.

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