Question

Case Study- Microsoft Solving a Good Problem for a Company to Have (2004)

Strategic Overview:

Microsoft announced at the annual shareholders meeting in November 2002 that, despite having $40 billion in cash on its balance sheet, the company would be taking any substantive measures to distribute the cash to its roughly 4.2 billion shareholders. Microsoft state that the cash was needed to satisfy judgements that could arise from ongoing corporate and private antitrust lawsuits. While the company had a history of buying back its stock, Microsoft had never paid a dividend since going public in 1986. The no dividend policy made sense historically as high-tech, growth companies with high P/E’s, typically don’t issue dividends, but instead elect to plow their profits back into the business. But as of the shareholder meeting, Microsoft’s growth had slowed to about 10 percent annually, from 30 percent or more in the company’s early years, and the stock, as evidenced by its inclusion in the Dow Jones Industrial Average, had begun to look more like a stable blue chip that a high-flying tech issue. The announcement made at the 2002 meeting angered many shareholders. Growth had stagnated and the company was sitting on a pot of cash. It was an efficient business that was generating $1 billion a month in free cash. In a shrinking interest rate environment, Microsoft’s returns on short term investments were insignificant and reduced the firm’s return on equity. The state of affairs led one investor at the meeting to comment, “We need a reason to hold the stock. We need a dividend. We need something.”

Options:

Management was under pressure to act. They could choose between a myriad of options including: 1) Doing nothing, 2) Using the cash to finance acquisitions and expansion, 3) Returning the cash to shareholders by beefing-up the ongoing stock repurchase program, a program that had the company buying back shares at the rate of up to $ 6 billion a quarter, or 4) Returning cash to shareholders by issuing dividends. Given the company had virtually no debt (see below), share repurchase appeared to be an efficient way to solve the problem. Buybacks are tax efficient to individua investors and protect shares from dilution due to option exercise. Unlike repurchases, investors assume that dividends payments, once begun, will continue indefinitely.

Decision:

In mid-January of 2003, three months after the November 2002 shareholder meeting, the company surprised the investment community by announcing its first-ever annual cash dividend of 8 cents per share (2 cents per quarter). The dividend represented a total outlay of more than $850 million which translated into just over a quarter of 1 percent of the share price. While the dividend made big news, it was met with criticism that the dollar amount was insignificant. Following the announcement speculation immediately rose over Microsoft’s change in philosophy. One suggested reason for the dividend was President Bush proposed tax reform plan which would exempt shareholders from income tax on dividends (later changed to a 0.15 tax rate). Another possible reason, and the one that Microsoft stated publicly, is that many of the company’s legal risks are largely behind them. The company settled with the Justice Department and many private antitrust claimants and has made progress with the European Union.

Shareholder Reaction and Company Update:

Microsoft’s stock price dropped about $4 or 7% the day following the dividend announcement. This was partially attributable to the relatively weak outlook for the current quarters, but the falling price was likely an indication that some investors concluded that Microsoft had exhausted its growth options and the future looked uncertain. Despite the dividend payments and despite the stock buy back, Microsoft continued to increase its cash balance. In July of 2004, the company announced it would issue a special cash dividend of $3 per share payable on December 2, 2004. With almost 11 billion shares outstanding, the special dividend would return almost $33 billion in cash to shareholders. In July of 2004, the company also announced that it would begin to pay a regular quarterly dividend of $0.08 per quarter. The move represented a doubling of the dividend – the second time the dividend had doubled since the initial dividend issuance. But even with the latest doubling, Microsoft’s yield will still be below the 1.7% average yield for the S&P 500.

Questions:

1. Was the decision to start paying a cash dividend of $0.02 per share per quarter a good decision?

2. Was the $3 per share special dividend desirable?

3. What, if anything, should Microsoft have done with its $64 billion of cash and short term investments?

Answer 1

1). The decision to start paying regular cash dividends signaled a strategic shift in Microsoft's policy to return value to stockholders as it had never paid dividends before and had instead chosen to do share repurchase. The move was an indication that the high growth, high risk phase was over for the company and it was a stable, blue chip IT stock. Combined with the fact that high legal risks for the company were over, it made sense for Microsoft to initiate a regular dividend policy.

2). Company's usually give out special dividends when they have excess cash which they wish to return to shareholders but at the same time, don't want to set a precedent of high dividends. Also, given that the low dividend payout of $0.08 per share was criticized by shareholders, it was the correct move to return cash to investors especially considering that it had substantial cash and short-term investments.

3). One important reason for companies to retain earnings is tax deferment. Taxes can be deferred on capital gains and recognized gains have a lower tax rate compared to ordinary income. Given this fact, company management takes into account tax laws while deciding upon dividend policy. So, for shareholders with significant holding, tax deferment is an important consideration. If Microsoft wanted to cater especially to large shareholders then the best move would have been to retain the cash and short-term investments.