Microsoft's middle-age spread

Shock is rippling through the finance world at the recent finance-related developments at Microsoft – at least among watchers close to the company. But curiously, the wider business world seems unfazed.

Although covered extensively in a handful of media reports, most of the changes have attracted note, but little comment. The bare facts have been reported, but little has emerged about the thinking behind the company’s recent moves, or the impact they are likely to have not just for Microsoft and its shareholders and employees, but for the wider business world.

Where Microsoft leads, others usually follow.

Let’s start with the facts. In its 28-year history, Microsoft, has never paid its shareholders a dividend – until now. What’s more, since its flotation on 13 March 1986, Microsoft has been one of the world’s most fervent issuers of employee stock options – until now. And despite numerous reorganisations, Microsoft has consistently remained a company structured around just two camps: techie software developers, and a skilled marketing and salesforce – until now.

Microsoft is abandoning the structure that has served it so well and is moving to the kind of product-centred divisional structure favoured by industrial giants such as GE. Each division will have its own cadre of financial managers and CFOs and will be a profit centre in its own right. There’s more. Microsoft has also fought shy of using management consultants – until now. Consulting firm McKinsey’s hands are all over the reorganisation. Undeniably, change is afoot.

So what’s going on? Several things. Take the sudden conversion to dividends, for example. To savvy investors such as Warren Buffett – coincidentally a close friend of Bill Gates – the anti-dividend attitude of Microsoft and most of its NASDAQ compatriots has long made little sense. (However, Warren Buffett’s own company, Berkshire Hathaway, hasn’t paid a dividend since 1967.)

But in the PC and internet boom of the mid-1980s to late-1990s, hi-tech companies had a good argument: we are better at investing your cash than you are. Retaining the earnings within the business – and then re-investing them – the logic ran, would yield more than the shareholders could get if they took the dividends as cash and ploughed them into other investments.

The argument had merit. In the 10 years from 1 January 1987 to 31 December 1996, for example, Microsoft’s shares rose by 6,252% – a spectacular return on investment. But even so, it’s a rate of growth that is impossible to continue ad infinitum, with or without Gates’ Midas-like touch. And growth since has been far less stellar, in part due to long-running legal tussles, but also due to the tech downturn, a saturating software and PC market, and a nervous investment climate.

The most telling argument, though, has been Microsoft’s massive cash pile: $49bn at the last count, and increasing at the rate of another billion every few months. Simply put, if Microsoft had so many lucrative new initiatives in which to invest shareholders’ money, why was it sitting on a huge wad of cash?

Now throw in American president George W Bush’s move to reduce the tax on dividends. Add a growing investor sentiment that wanted to see the prospect of continued capital gains tomorrow with the certainty of income streams today, and the decision virtually made itself. On 16 January, the company announced a 2-for-1 stock split (in order to make the stock “more accessible to a broader range of investors”, according to company spokesperson Caroline Boren), adding that an $0.08 dividend would be payable on each of the new shares on 7 March.

The immediate effect of the announcement fell somewhere between a damp squib and a whoopee cushion. First, the damp squib. Although characterised by CFO John Connors as a “starter dividend”, the $0.08 per share was hardly anything to get excited about, totalling just $870m – almost chump change compared with the $49bn cash piles. The whoopee cushion effect was just as clear: Microsoft shares fell $0.07 per share on the news. “The day Microsoft declares a dividend is the day that people no longer think of it as a growth stock,” said one analyst. “The days of 40-50% profit and revenue growth are not likely to recur.”

But the long-term effects will be far more significant. Although the company has downplayed the impact of the change in dividend taxation on its decision (a move that will, in effect, see Bill Gates, Microsoft’s single largest shareholder, receive his almost $100m dividend tax free), the announcement had a cathartic effect in boardrooms across America.

Yahoo and ebay both acknowledged they were contemplating dividend payments, while Hewlett-Packard and IBM announced plans to increase existing dividend payments. And on 14 July, financial services giant Citigroup announced that its dividend payouts would in future be more substantial – backing the words with a 75% increase in dividends to an annual total of $3bn.

So why did Microsoft decide to throw 28 years of history out the window and pay a dividend? Beyond denying that it reflected a lack of more profitable opportunities to invest the money, Microsoft officials have remained tight-lipped. Chief executive Steve Ballmer, for example, said precisely zero about the move in a recent – and, as usual, expansive – speech to financial analysts on 24 July.

In fact, Ballmer is the one who should be credited with much of the thinking behind the move, reflecting as it does a sequence of changes that he made in the company since a Damascene conversion took place – as recently reported by the Wall Street Journal – while reading GE CEO Jack Welch’s Jack: Straight from the gut (originally published in the UK as What I’ve learned leading a great company and great people) while on a business trip to Europe in the autumn of 2001.

The critical moment, it seems, came at 3am one morning in a Paris hotel, when after two straight days of 16-hour meetings, Ballmer reportedly summoned a top lieutenant into his room to discuss what the chief executive’s role should be. Although still daunted by the challenges ahead, says group vice president Jeff Raikes, Ballmer could clearly see there had to be a better way of running things.

The answer was a divisional structure, based around product lines, and a beefed-up management team in each division to handle all the detailed decisions that always seemed to wind up in Ballmer’s in-tray. What worked so well for GE, says Ballmer, could well do the trick at Microsoft.

Others weren’t so sure, and tensions between Ballmer and CFO Connors ratcheted up several notches as the details were thrashed out. Connors, a finance veteran of many years, could see pitfalls ahead if Microsoft’s long-neglected and underfunded finance function wasn’t beefed-up before making the move. Specifically, it lacked an insight into how other companies with such structures actually operated – and it also lacked finance executives with experience of working within such structures.

Out came the chequebook. First, to hire McKinsey to study a host of big name corporations and come up with a framework for a finance organisation: McKinsey consultants duly headed off to giants such as GE, Sony, Merck and Johnson & Johnson. Second, to hire seasoned finance executives to, in effect, become the chief financial officers of the proposed seven Microsoft operating divisions. Executives from Dell, Exxon Mobil, Hewlett-Packard and Walt Disney came on board.

But perversely, many of those new hires were to be affected by the latest financial bombshell to emerge from Microsoft. For as long as it had been parsimonious with dividends, Microsoft had long been lavish with stock options. The arguments were well rehearsed and trotted out routinely by Microsoft executives: options encouraged effort, aided retention and created a sense of ownership. The darker side of options, of course, is equally well known: they are, in effect, a free way of paying people, using no cash and without impacting profits.

This isn’t the place to weigh up the merits and downside of options. But there’s little doubt about two straightforward facts. First, analysts calculate that a little over 50% of all outstanding options are under water; in other words, the strike price is higher than the price at which the shares are trading. In that environment, options’ impact on motivation and employee retention remains dubious. Second, corporate America’s reliance on options has had a huge distorting effect on profits and capital structures.

Had options been expensed, as critics charge, then their impact on corporate profits in 1996 would have been a reduction of just 2% in reported profits.

Do the same exercise in 2002 and the impact would have been a whopping 23% write-down. And just look at the effect on outstanding shares. Southwest Airlines has 326% more shares today than it had in 2001. Campbell Soup has 301% more, and Conoco Philips – a whopping 600% more shares.

Microsoft has hedged its bets. It’s still a believer in the equity culture: employees will still get a stake in the company, announced Ballmer and Connors on 7 July. But those stakes will be in the form of a smaller amount of paid-up restricted shares, funded from existing profits and cash. And any options the company does give out in future will be fully expensed – no more blank cheques written today to be presented for payment to tomorrow’s shareholders.

Whatever its merits, Microsoft can afford the move – that $49bn isn’t going to evaporate any day soon. But the move has set a hare running that will scamper across just about every corporate boardroom in America. At present, only a tiny majority of companies expense options – and many of the larger ones to do so, such as Coca-Cola, have links to options’ greatest critic, Warren Buffett, a Coca-Cola shareholder and director.

Now, many more are facing up to the fact that they, too, might have to expense options and in the process take a hit on their P&L – which won’t be insignificant: remember that 23%.

It’s a little late, but as it approaches its 29th birthday, Microsoft has finally come of age and matured. It has been a hell of a party, but the hangovers will be hard to shake off.