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Microsoft: Buyback or the Bahamas?
Investors want to know just how Microsoft plans to spend its $56.4 billion. We offer a few ideas.
June 22, 2004: 8:40 AM EDT
By Paul R. La Monica, CNN/Money senior writer

NEW YORK (CNN/Money) - Wall Street is beginning to fantasize about all the ways that Microsoft can spend its $56.4 billion in cash.

Microsoft's chief financial officer told investors in February that the company would give the Street an outline of how it intends to use much of its cash before the end of July. Investors are hoping to hear more details during the company's fiscal fourth quarter earnings report July 22 or at Microsoft's analyst meeting July 29.

And with the dates of these meetings drawing nearer, shares of the world's largest software company have finally started to show signs of emerging from their nearly two-year long funk. Microsoft (MSFT: Research, Estimates) is up nearly 10 percent in the past two weeks and is now just 6 percent off its 52-week high.

"Microsoft has been acting a little different lately," said Michael Cohen, director of research for Pacific American Securities. "It seems to be awakening from its long slumber."

Investors are excited because they expect Microsoft to use a significant chunk of its coin to launch a large share repurchase program.

Even though a buyback would do nothing to change the sales outlook for the company, Wall Street would probably approve simply because, by lowering the company's available share count, Microsoft would be able to boost earnings per share.

"A lower share count is what it is," said Ted Parrish, co-manager of the Henssler Equity fund, which owns Microsoft. "Let's face it. Microsoft's revenue base is so large, it can't achieve the type of revenue growth that it did in the past."

But Parrish said that the earnings lift from a buyback could make Microsoft what he considers a "mature growth company" like IBM, for example.

$100 billion buyback? Not likely.

So how much should Microsoft spend on a buyback? In a recent research report, Goldman Sachs analyst Rick Sherlund estimated that if Microsoft bought back $10 billion's worth of stock, this would lead to about a 2.5 cent per share increase in earnings for fiscal 2005.

Sherlund went on to speculate that if Microsoft wanted to be truly aggressive, it could use all of its cash and its long-term investments, which amounts to about $70 billion, and then borrow an additional $30 billion in order to finance a $100 billion share repurchase that would add a full 25 cents per share to next year's earnings.

Shares of Microsoft have been stuck in a range for the past year but have shown some signs of life lately.

However, the likelihood of Microsoft going $30 billion into hock in order to buy back a third of its shares outstanding seems about as plausible as some of the more creative ways we've come up with for Microsoft to spend its money, such as acquiring Starbucks, all three Seattle professional sports teams and the Bahamas.

Investors should remember that Microsoft chairman Bill Gates wrote in his 1995 book, "The Road Ahead", that one of his main rules in running Microsoft was to always have enough cash on hand to make it through a year even if nobody paid the company.

Through the first three quarters of fiscal 2004, Microsoft had $21.6 billion in operating expenses. That averages out to about $7.2 billion a quarter. Assume Microsoft spends a similar amount this quarter, which ends in June. That works out to about $29 billion, leaving Microsoft with about $27 billion in cash to actually use, rather than save for a doomsday scenario.

With that in mind, Adam Adelman, senior analyst with Philippe Investment Management, a money management firm that owns Microsoft, said he doubts the company would spend much more than $10 billion on a share buyback. But he thinks that would be enough to justify investors' recent enthusiasm.

"This uncertainty about what Microsoft is going to do with the cash has been hanging over the stock for a couple of years," said Adelman. "A buyback would be a signal that management is optimistic with the price of its own stock."

Dividend boost is likely

A share buyback is not the only option for Microsoft, however. The company could also increase its dividend or issue a one-time special dividend. In fact, Cohen said he expects Microsoft to both increase its dividend and institute a large buyback.

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Microsoft began paying a dividend in March 2003 and doubled it in September. Nonetheless, the yield for Microsoft's stock is just 0.56 percent, the second lowest of the 30 stocks in the Dow Jones Industrial Average after AIG's roughly 0.4 percent.

However, Parrish said a big dividend increase would be the worst option for Microsoft shareholders. He thinks that if Microsoft raised its dividend drastically or paid out a large one-time special dividend, the market would interpret it as a sign that the company has nothing better to do with its cash.

Parrish said Microsoft could probably get away with doubling its dividend again, to 32 cents per share. Based on current share count figures, that would cost Microsoft an additional $1.7 billion a year. In addition, a dividend of 32 cents a share would amount to just under 25 percent of Microsoft's estimated 2005 earnings, leaving the company with ample financial flexibility.

Microsoft Corporation
Bill Gates
Computer software

To that end, Parrish said that despite the stock's recent climb, he would still like to see Microsoft use a decent amount of its cash to buy into higher growth areas of software. Speculation about Microsoft making some sort of deal has increased since the company disclosed two weeks ago that it held merger talks with German software giant SAP last year.

"I want to see Microsoft do something that can help them on a going concern," Parrish said. "I'd rather see the company make some sort of deal but if there aren't any acquisitions available, I'd settle for a buyback."

We still like our idea of buying the Mariners, a tropical island paradise and lifetime supply of frappuccinos better though.

Goldman's Sherlund does not own shares of Microsoft but his firm has an investment banking relationship with the company. Pacific American's Cohen does not own the stock and his firm has not done investment banking for Microsoft.  Top of page

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