Monday, June 1, 2009

Microsoft's leverage nearly triples!!!

Microsoft borrowed $3.8 billion in the US corporate bond market on May 11, driving its total debt up to $5.8 billion. But there's no need for panic. The company had $36.9 billion worth of cash and investments at the end of March, was producing annualized EBITDA of $23.4 billion, and enjoys triple-A ratings from Moody's and Standard & Poor's.

Cash flow problems?

The question for Microsoft is, why borrow at all? Companies borrow for lots of reasons. One is to make up for weak or erratic cash flows. That doesn't seem to be Microsoft's problem. It's been generating strong free cash flows and stable free cash flow margins.

* Last 12 months as of March 31, 2009

(Free cash flow margin is a concept developed by the Georgia Tech Financial Analysis Lab, a leader in cash flow analytics. For more information go to We calculate free cash flow somewhat differently from them in this analysis.)

Liquidity Reserves?
Another reason is to build liquidity reserves by borrowing long-term money and keeping the proceeds on hand to meet future needs. But that's typical of lower-grade companies with erratic cash flows or unpredictable cash needs, not a highly rated company with strong cash flow and few financial contingencies, like Microsoft.

War chest?
Another reason to take on more debt is to build a war chest for acquisitions. The likely target for Microsoft is Yahoo, which has a market capitalization of about $21 billion. It might cost Microsoft $25 - $30 billion to acquire Yahoo, but Microsoft doesn't need to borrow money for that. It has $37 billion in cash and investments in reserve.

Cost of capital might be the reason. Following the precepts of modern finance, companies like to blend debt with equity in their capital structures to reduce the weighted average cost of capital. Debt is cheaper than equity up to a point, but that point is somewhere around 45% debt capitalization. At only 13.6% debt to capital, Microsoft is a long way from its optimal capital structure.

Market Access?
The last reason for using debt is market access. Companies often borrow to establish themselves in the debt markets. That helps the company's financial managers get familiar with market underwriting standards and practices and gives lenders and investors a chance to become familiar with the company's management, operations, and finances.
With this bond issue, Microsoft is now active in the syndicated bank loan, commercial paper, and bond markets.

Microsoft's Motives?
So which reason is it for Microsoft? It's probably a combination of reasons. The prospectus for the bonds says the funds are for "general corporate purposes." We think its most likely for debt market access in anticipation of a major acquisition which might affect liquidity needs.

Risk and Structure
Why does all this matter from a credit risk perspective? Understanding the purpose of the loan is one of the fundamental tenets of credit analysis. For large, investment grade companies the purpose can be very vague ("general corporate purposes"), but for smaller, weaker companies it should be more precise ("working capital financing" or "new equipment purchases").

From a credit structuring perspective, the basic rule is to match the form of the credit to the nature of the need. For a general purpose loan, a revolving credit or a long-term bond would be the best fit (Microsoft's bonds were for 5, 10, and 30 years). For specific needs, the rule of thumb is to match the maturity of the credit to the life of the assets, with short-term lines of credit for working capital and medium-to-long-term loans for fixed assets.


Arthur James said...

Perhaps the most dubious goal is to lower the WACC in order to increase the firm valuation. The corporate landscape must be filled with over-levered companies that borrowed too much when debt was cheap and plentiful and are now being forced to raise equity in order to de-lever.

Tim Delaney said...

I agree. Optimizing WACC seems more compelling in theory than in practice. Too many MBAs took on too much debt, either in leveraged buyouts or to fund aggressive share repurchase programs. Michael Milken lays it all out in his Wall Street Journal article "Why Capital Structure Matters" (April 21, 2009). It's ironical to read the king of junk bonds rail against debt, but he makes a great case for avoiding financial leverage.