This may sound like a long time ago, but it was not. Shares of the company first went public at $20.75 in the form of a reverse merger with a now-legendary investment company called Nelson Peltz. The Bill Gates made the $1 transaction in January 1977. Since then there have been periodic share splits to smooth out share price fluctuations. From its spin-off in 2004, Microsoft is trading at $53.99 at the time of this writing.
During this time period, a shift in the Microsoft management philosophy is also notable. Nelson Peltz became active in the company and paid more attention to driving share buybacks. The amount of Microsoft’s share buybacks in the six year period before his arrival were $5.8 billion. This amounted to 15% of total share count. Over the same period, Microsoft itself bought back $4.65 billion in all. For shareholders, this was worth an approximate $1.3 billion in Microsoft’s return of capital. At the time of the spin-off, William F. Smith, the chief operating officer of the Microsoft executive council, was returning $28 million in dividends and $77 million in special cash dividends to investors. Both Frank Shaw, executive vice president of the Americas, and Ben Rothstein, senior vice president of the Americas, received share dividends of over $48 million each.
The thesis for Microsoft is that the company has experienced several ups and downs, and that significant changes in corporate management were needed. In truth, for the longest time, Microsoft management was not responsive to investor complaints. Share buybacks in the years following Nelson Peltz’s arrival would not be possible without a very limited budget. Further, business conditions would not have changed at all. Instead, Microsoft’s business was dependent on the Microsoft operating system. Operating systems are the foundation for a number of publicly traded software companies. And Microsoft came very close to folding the operating system.
In July 2005, Microsoft agreed to buy Online Services from the BBC. Following this acquisition, the company lost the subscription licenses to use its Windows operating system, locking it out of lucrative new corporate deals. The worldwide impact on earnings from this was 1-3 cents per share. By the end of 2005, the company issued roughly $10 billion in stock-based compensation to employees. Together with the 5 percent distribution of unrestricted cash to owners of the company, the shares grew 15 percent in total value from its price at the end of 2001 to its current level.
Also during this period, the Windows operating system was radically altered. In the six years between its acquisition by Microsoft, the operating system grew from 2.1 million copies shipped worldwide in 2003 to 20 million in 2005. The operating system is a fundamental basis for thousands of applications for business and personal use. It has a pervasive presence in every office, home, and car on which it operates.
The philosophy behind the expanded equity ownership is that shares of Microsoft should only be traded on the over-the-counter exchange and should yield a few million dollars in dividends per year. By contrast, share buybacks reflect managements’ desire to repurchase the right to sell Microsoft shares in the future for future cash earnings. Additionally, the recent multi-billion dollar dividend by the company should reduce the need for any additional share buybacks.
Microsoft shares continue to trade at a price to earnings ratio of 25. At current prices, Microsoft shares have a market capitalization of $200 billion. How Microsoft management allocates capital is important. Share buybacks are useful and can be done. However, it is highly unlikely that this will happen without a capital allocation decision by management. And management should be prepared to make their own decisions. If management had this capability, the stock price would be in a relatively predictable range. The natural consequence is that investors would not necessarily notice any changes.
The principal take-away from this article is that Microsoft has suffered several mistakes in recent years. It’s reputation may have improved, but the company still relies on software revenue. Microsoft’s success or failure is actually predicated on whether this software company can make money from its current users and the platform. It is difficult to make money in this world of information and computing.
Current Microsoft shareholders should plan for a future in which Microsoft will suffer losses, but the profits from the platform will continue to bolster earnings. Because Microsoft is committed to earnings and the user relationship remains positive, Microsoft shares remain relatively cheap and can be bought at their current price.