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Microsoft's Best Use of Cash

Contributed by mm | April 24, 2004 8:44 AM PST

Although Microsoft promises to give an answer to the use of its cash pile in July, people are already starting to speculate different options. However, sometimes they just cannot get the point.

A recent TheStreet.com article Microsoft Bulls Still Play Waiting Game quoted the thinkings of a Smith Barney Citigroup analyst:

"Smith Barney Citigroup analyst Tom Berquist noted that such a one-time dividend would amount to a big bonus for Microsoft employees who hold shares, giving them an excuse to leave the company. "My feeling is Microsoft wouldn't want to reward employees to that degree," said Berquist, who has a buy rating on Microsoft. (His firm has done banking with Microsoft.)"

(To put it into context, in the latest quarterly earning release, Microsoft reported 56.4 billion dollars position in cash and short-term investments. With approximately 10.8 billion shares outstanding, the most Microsoft can pay out in a single dividend is $5.)

I am completely surprised by the reasoning. A big one-time dividend is nowhere near a big bonus for employee shareholders. The moment the dividend is paid to shareholders, the moment Microsoft as a stock will fall for almost the same amount. So while employees who hold MSFT shares (or any other Microsoft shareholders) can get some cash dividends, their MSFT share price is going to drop. (A recent example is TheStamp.com, which paid out a cash dividend of $1.75 in February. The stock price dropped from $8.10 to $6.40 the day after the dividend payout.)

Actually, there are only two marginal benefits of a big one-time dividend:

1) Dividend will be taxed at no more than 15% while capital gains can be taxed as high as 35%. The different in 20% tax rate can amount to $1/share benefit, or 4% gain on Microsoft stock holdings (MSFT is trading at $27 after the earnings release.) Yes, it is some financial gain, but it is not even close to be "an excuse to leave the company." (Will you quit your job and retire if your net worth increases by 4% overnight?)

2) The theory of paying out a big dividend is because supposedly shareholders can better manage the cash than the company, now that Microsoft apparently cannot invest the cash in its core software business. However, in the most recent quarter, Microsoft reported total quarterly investment income of $1,012MM, which is about 7% annualized gain. It is a pretty high bar for ordinary people to overcome if they are to invest the cash themselves. Therefore, this aspect of the potential benefit about a big payoff is illusive.

Now that we know the benefits of a big dividend is far from a windfall that will cause a lot of employee resignation, I am equally surprised by the fact that this comes from a Smith Barney analyst because Smith Barney is facilitating Microsoft's Employee Stock Option Program. I know there will be a "Chinese wall" between analysts and investment bankers (who are managing the stock option program), but the above statement shows total ignorance of Microsoft ESOP as an important component in Microsoft's pay package. In fact, a big dividend will hurt ESOP holders badly and cause a lot of employee dissatisfaction, because stock price will drop for sure, and it is almost impossible that the outstanding options will be repriced accordingly, resulting a tremendous loss for ESOP holders.

In short, this Smith Barney analyst got the right conclusion from flawed reasoning.

(By the way, in my guess, I think the final answer to the best use of Microsoft cash will be a mix of increasing buyback plus a small dividend increase, which represents the best balance between shareholder and employee interests.)

This Post Has Received 1 Comment. Share Your Opinions Too.


Motts McGregor Commented on April 24, 2004

Hello.

The reason why a special dividend rewards employee shareholders disproportionately is that employees -- particularly senior execs with large holdings -- are, by virtue of the scrutiny associated with large insider sales and internal restrictions thereon, less able to sell on the open market and create a synthetic "dividend" for themselves. Non-employees have no such constraint.

I would say further that number 1 above is a net negative for employees relative to outside shareholders as employees have likely been holding their stock for a rather longer period and would therefore be subject to LTCG treatment anyway, if they were (able) to sell.

-Motts


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