Tuesday, September 17, 2013

Microsoft's 22% Dividend Hike: What's The Signal?

So Microsoft raised its dividend 22% ahead of its Analysts Day.  This compares to a widely expected level of 15%.  It also announced a $40 billion share buyback authorization. From John Lintner's 1956 publication, the notion of dividends as signals to the investor marketplace is widely spouted, but not well understood.

So, in the case of Microsoft what could the dividend and the buyback be signaling?  Here is a succinct summary of the signaling case from a 2011 paper by Baker and Wurgler of Harvard Business School and Stern School, respectively,
"Standard dividend signaling theories posit that executives use dividends to destroy some firm value and thereby signal that plenty of value remains. The money burning takes the form of tax-inefficient distributions, foregone profitable investment, or costly external finance."
The research from investment analysts and management consultants on whether share buybacks add or destroy value has generally been negative.  According to a Credit Suisse report by Zion, Varshney, and Burnap from June 2012, the information technology sector bought back $619 billion of stock from 2004-2011, accounting for about 23% of all buybacks from the ten Standard and Poors industry sectors; information technology was number one by a wide margin.  So, in a sense, buybacks come with the territory of being a technology leader.

The Credit Suisse analysts, when they use a benchmark cost of equity against which to evaluate the economic value-added from a buyback, note that only 36 percent of the Standard and Poors companies which bought back $2.7 trillion of their shares during 2044-2011 added value by doing so.  So, 64 percent of our leading public companies destroyed value by their share buybacks.

What's more out of the Top 10 companies that spend more than $1 billion in share buybacks and earned the highest annualized returns above their costs of equity, none of them were in the information technology sector. Rather they were in prosaic industries like tobacco, retailing, and distribution. One financial services firm and a medical device company were in the group.  So, tech companies don't seem to play this game well, according to the most recent period surveyed.

(A 2012 paper by Lambrecht and Myers of the University of Lancaster and MIT Sloan, respectively gives another, more provocative theory about share buybacks.  For those readers who like academic research.)

Microsoft is being set up by the press as facing a tough Analysts Day.  Compared to the HP Investor Day, this one looks extremely bland, more like an extended conference call. Investors have seen their company destroy value through repeated, fundamental misreadings of the evolution of personal and business technology, together with acquisitions that seem to trail innovation rather than blaze the path.

Investors are not worried about the level of dividends or share buybacks.  They want to know if their company will continue to be a leader in the new technology bazaar, not the old Technology Officers Club. Some of the key questions are corporate organization, executive management, the portfolio, allocation of capital, the innovation process, management incentives, and the CEO succession.  Unfortunately, all of these are effectively off the table due to the timing of announcements, by fiat in the case of CEO succession, and by the fact that there are no answers now.

$1.5 billion in Office 365 revenue is pointed to as indicating great things.  I have my doubts, but the truth is that the rationale for consumers and business adopting this model has not seemed convincing.  I recognize that there is some rationale for big corporate licensees, but that's assuming that they don't eventually get fed up and go to a better option being developed elsewhere.

Arrogance and the power of the monopolist is what built the company's cash horde.  The Windows model is winding down, perhaps slowly but inevitably. Trying to become a consumer oriented company around hardware goes against the company's evolutionary DNA.  Consumers are price-driven, fickle, demanding and always set to move to the next big thing.  Microsoft is unlikely to become a leading gaming or entertainment company under its current structure.  How are these issues going to be resolved?

This is where the value will be added, not by short-term share buybacks and dividend hikes.  Microsoft's board charter should to make sure that the company stays in business forever, to paraphrase Harvey Mackay.  Given its current financial strength and many assets, investors need to understand how the past egregious destruction of value will give way to a new era of value creation.  That is the beginning and the end of the story.

Let's see if we know anything more after the Analysts Day.

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