Why Microsoft Uses Debt for Linkedin

 

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Microsoft will issue debt to purchase Linkedin. We learned that this month along with the nuances of tax repatriation.  A lot in taxes will be paid if Microsoft buys Linkedin with overseas cash. Most of Microsoft’s $107 Billion in cash and cash equivalents are held outside the United States. But to avoid taxes, Microsoft could have use stock to purchase Linkedin.

Overseas cash wasn’t a problem in the past when Microsoft acquired Nokia, Skype, and recently Mojang Synergies (Minecraft). All those acquisitions were done, not with stock, but with cash: $3 Billion for Mojang, $7 Billion for Nokia, and $9 Billion for Skype. Using cash made sense, because all three companies were overseas and so need to repatriate any cash. Now Microsoft will do the same, buy Linkedin with cash.  

The tech press touted the sheer genius of Microsoft: the interest on the debt is tax deductible! Yes it could be, but it really isn’t that much. Last November 2015, Microsoft issued $13 billion in debt, paying an average interest rate of 3.00%. Using the same interest rate means Microsoft will pay $780 million in interest expense to acquire Linkedin. But since Microsoft’s effective tax rate is 27%, the tax deduction is only $210 million per year.

Generally, the tax department is not a profit center.  Microsoft makes money selling software and services; tax savings are extra. From a financial perspective, Microsoft is just moving cash from overseas to here. In the end, Microsoft breaks even. Interest income earned overseas is offset by the interest paid on newly issued debt. In fact and surprising, a majority of the overseas cash is invested U.S. government and affiliated debt, which may not pay the highest rate.

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Taxes aside, the biggest surprise is that any of this is news. In its annual report, Microsoft said it will continue to use debt, instead of repatriating cash, as long as interest rates remain low (Liquidity Section of the 2015 Annual Report). In addition, Microsoft said back in November 2015, that the $13 billion debt offering could be for the following (italicized):

Microsoft intends to use the net proceeds from the offering for general corporate purposes, which may include, among other things, funding for working capital, capital expenditures, repurchases of capital stock, acquisitions, and repayment of existing debt.

Instead of cash, Linkedin could have taken stock. Maybe Reid Hoffman didn’t want stock, despite the tax savings to him of receiving stock instead of cash. Maybe Microsoft just wanted to use cash or maybe, as Microsoft said, issuing stock would result in a “dilution of our earnings” (See Liquidity Section of the 2015 Annual Report)

More stock lowers Microsoft’s stock price, which it doesn’t want. In fact, Microsoft has been doing the opposite. Borrowing IBM’s strategy, Microsoft has been buying back its stock. By reducing the supply of stock and increasing earnings per share, Microsoft magically increases the stock price for a company that is no longer a growing one.

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Salesforce’s Linkedin Bid Masks Cash Flow Issues

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Salesforce made an attempted bid for LinkedIn. That news makes sense since Salesforce grows through acquisitions rather than internally. But Salesforce’s acquisitions limits the free-cash flow available to shareholders. In its most recent filings, Salesforce disclosed along with other non-GAAP metrics, its free-cash flows. After adjustments, there is no so much cash left.

For fiscal years 2014 through 2016, Salesforce’s free-cash flows was approximately $600 million, $900 million, and $1.3 billion.  To arrive free-cash flows amounts, Salesforce started with cash generated by operations and then subtracted capital expenditures. And what is left, is the cash available to investors.

Capital expenditures need to be subtracted because the company needs to re-invest in order to grow future cash flows. For 2014-2016, Salesforce spent approximately $300 million per year on capital expenditures. Normally, that would be end of the calculation, but Salesforce is not a normal company. So we must continue on.

 

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Professors Charles W. Mulford and Eugene E. Comiskey propose in Creative Cash Flows Reporting, that a company’s free cash flow should be adjusted when numerous acquisitions are made during the year. They argue that the “ growth the operating cash flow and free cash flow may depend more on the acquiring firm’s ability to close numerous transactions than its ability to grow its cash flows internally”.

Salesforce has made ten acquisitions in FY 2014 to FY 2016; the largest was the acquisition of ExactTarget for $2.6 billion. In addition, Salesforce makes investments in early stage companies, which could be seen seen as an option on future acquisitions.

Taken together, both amounts would need to deducted following the two Professors’ reasoning. When subtracting Salesforce’s strategic investments and acquisitions, the free-cash flow from FY 2014 to FY 2016 is now ($2 billion), $500 million, and $900 million.

Also subtracted from free cash flows is stock used in acquisitions. Normally a non-cash item,  stock used in acquisitions should also subtracted, the two Professors argue. In FY 2015, Relate IQ, Inc. was acquired with mostly stock valued at $340 million.

For the most recent quarter, Salesforce purchased Steelbrick for $314 million in cash and stock. For the quarter ended April 20, 2016, Salesforce’s reported free-cash flow of $968 million.  After deducting the amounts associated with acquisitions, the free cash flow is $665 million, or 30% less.

Next quarter may not be any better – Salesforce announced in June the purchase of  Demandware for $ 2.8 billion.

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Twitter Is Not For Sale!!!

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Twitter’s stock price is down, way down. And the announcement of Microsoft’s acquisition of LinkedIn, has many speculating if Twitter is next.

Twitter is not for sale or at least it is difficult to be acquired. If Twitter was to be acquired, the buyer would not get  Twitter’s most valuable assets – its tax losses (called net operating loss carry-forwards).

Twitter has not yet made a profit and has not ever paid any taxes. But someday, hopefully, Twitter will be profitable and when it does, it can use it accumulated losses to reduce any taxable income and consequently any taxes owed to the Federal Government.

At the end of the last year, the tax losses were $3.4 billion dollars. Said another way, Twitter can have taxable profits of $3.4 without paying taxes. But that tax benefit would be lost if the company was acquired, if you want to read it, here it is (page 33):

…….if a corporation undergoes an “ownership change,” the corporation’s ability to use its pre-change net operating loss carryforwards and other pre-change tax attributes, such as research tax credits, to offset its post-change income and taxes may be limited…

That means the tax benefits will be gone if there is a more than 50% change in ownership. The loss of tax benefits may not matter to an entity that does not pay taxes, but it would be an important issue to an acquirer who is profitable and does pay taxes, such as Microsoft.

LinkedIn has been profitable and has no net operating loss carry-forwards, so it’s not a deal breaker for Microsoft.