Triple-A rated Microsoft and Hasbro are turning up the gears in buying back stock.
Following what can best be described as a difficult quarter, Microsoft (MSFT) is stepping up its game in buying back its own undervalued stock. Before the end of 2016, the software giant plans to put to work the $31 billion remaining on its share repurchase program. To help it do so, the company is selling $7+ billion in debt, and the timing couldn’t be better. Shares of Microsoft are hovering just over $40 each, and with our fair value pegged in the mid-$50s, levering up the company via buying its own underpriced stock makes a lot of sense.
The financial team at Microsoft is creating significant economic value by this move.
Microsoft’s Dividend Cushion ratio is north of 3 at present, and while adding debt to buy back stock will lower its coverage of the dividend a bit, the firm generates gobs and gobs of free cash flow, to the tune of $26.7+ billion in the last fiscal year alone. What’s a measly $7 billion in incremental debt, right? After all, Microsoft ended calendar 2014 with over $90 billion in total cash and short-term investments. It’s almost as if Microsoft is floating this debt to remind the equity and credit markets of the extent of its financial health.
From our perspective, Microsoft’s dividend may be the strongest 3%-yielder on the market today. That’s why it remains a key position in the Dividend Growth portfolio, even as we took some profits more recently. Though we have a few concerns with Microsoft’s technicals at the moment, we don’t have any concerns with the triple-A-rated firm’s ability to keep raising its investors’ income streams year after year.
Ideally, we’d like to see Microsoft up its dividend payout by $0.46 on an annual basis, to $1.70 per share, creating a ~4% annual dividend yield at current prices. At that level, we would expect substantial fundamental support for the stock. Such an increase would represent a rather large ~40% bump from current levels, but the revised annual dividend payout would only amount to $14.1 billion annually on its ~8.3 billion shares, still less than half of Microsoft’s free cash flow generation in any given year.
Importantly, however, as Microsoft buys back more stock, its annual dividend obligations at a higher payout level shrink relative to the obligations that it otherwise would incur with the higher share count. Perhaps this is exactly what Microsoft is doing with its aggressive buy backs – setting up for a huge dividend increase on a reduced number of shares. In this light, it’s difficult to not be excited about the debt deal.
Another Dividend Growth portfolio holding Hasbro (HAS) reported a fantastic fourth quarter. I can’t begin to tell you how pleased I am with the firm’s performance relative to Mattel (MAT). We clearly picked the winner of the two, and we have the Dividend Cushion ratio to thank for that. Excluding currency impacts, net revenue advanced an impressive 7% in its calendar fourth quarter, as adjusted net earnings swelled to $1.22 per share, up a dime on a year-over-year basis.
Not bad for a toy company, no?
Well, as we’ve said time and time before, Hasbro is no such thing – it is a licensing company, and the market is finally figuring it out. Hasbro’s shares surpassed $60 during trading following its release, and we’re letting this winner run. We value the company at $62 per share at present. It was added to the Dividend Growth portfolio in the low-$30s.
Hasbro also announced that it has bolstered its share repurchase program by another $500 million. Though we like the news, the value-creating impact of its buyback program won’t be as large as that of Microsoft’s because Hasbro’s shares are trading relatively close to our fair value estimate. Microsoft, on the other hand, continues to trade at a steep discount to our estimate of its intrinsic value.
Remember, when it comes to buybacks, not all of them are value-creating. If shares are overvalued, management is destroying value in buying back stock, akin to the same risks that investors take when investing in overpriced stock themselves. Only when shares are undervalued do buybacks make sense.
In both Microsoft’s and Hasbro’s cases, they do.