Microsoft opens windows | Structured Equity | IFRe

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Friday, 28 September 2012

Microsoft opens windows

IFR 1837 12 June to 18 June 2010
Convertible bonds have been maligned by some as small and susceptible to market disruptions. At roughly one-third the size of
the high-yield market, the asset class has been acutely affected by the credit and stock market volatility of the recent past.
Microsofts decision to fund a share repurchase with the proceeds of a US$1.15bn convertible bond suggests a potential
renaissance for the asset class. Stephen Lacey reports.
Computer technology corporation Microsoft has unfettered access to capital. With a cash hoard approaching US$40bn, the
software giant can raise as much capital as it needs and through whatever form, be it equity, debt, commercial paper or loans. The
company flexed that muscle last week by raising US$1.15bn from the sale of a convertible bond on which it will pay no interest
during the next three years, trumping all other forms of capital.
Joint bookrunners Citigroup, Bank of America Merrill Lynch, Barclays Capital and UBS marketed the three-year CB, which cannot
be called or put for life, for one day before finalising pricing late on Tuesday night at a zero coupon and 33% conversion premium,
versus talk of zero fixed and a 30%35% premium.
The final terms implied a credit of Libor plus 10bp and a vol of 23.5%, reflecting the clout of Microsoft, rated AAA, as well as a
unique pairing of credit and vol that allowed for pinpoint pricing.

Source: REUTERS/Mark Blinch

Microsoft, whose Windows operating system
dominates the worlds personal computer market, last
week trumped all other forms of capital by raising
US$1.15bn from the sale of a convertible bond on
which it will pay no interest during the next three years.
Versus a 1.3% decline in the underlying, the Microsoft CB closed Wednesday trading at 99.5899.70, unchanged on a dollarneutral basis.
It really didnt make much sense for us to participate, said Michael Kao, CEO of Akanthos Capital Management, a convertible
arbitrage firm based in Los Angeles. Its a zero coupon bond that priced at an aggressive theoretical valuation. That said, it is a
very significant transaction for the convertible bond market.
Indeed, the transaction is emblematic of the significant transformation in the investor base for convertible bonds. Technical
investors remain an important constituency, but are increasingly being forced to compete with long-only, outright investors on new
deals. Both were integral to the execution of the Microsoft CB, as expectations of heavy outright participation prompted arbs to lift
their bid.

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The level of convertible arbitrage participation has changed quite significantly over the last two to two-and-a-half years, said Venu
Krishna, head of US equity-linked strategies at Barclays Capital. Weve seen a lot of crossover buyers come into the market.
According to a study conducted by Barclays Capital, 53% of the convertible bonds outstanding at the end of 2009 (US$244.9bn, as
measured by market value) were held by outright investors, and the balance by convert arb funds. That compares with a 26%/74%
mix of outrights/hedge funds at the end of second-quarter 2008 (US$354bn), before Lehman Brothers bankruptcy and the onset of
the credit crisis.
The participation of outright investors was instrumental to the reopening of the CB market in early 2009. Then, as now, their
motivation is to participate in the equity upside at a time of historically depressed valuation through an instrument that provides
downside protection. The bond floor on the Microsoft CB is about 95.50.
The market value of the US convertible bond universe, 682 securities, stands at US$241bn, as measured by the Barclays Capital
US Convertible Bond Index. That compares with US$799.3bn for the US high-yield universe, as measured by a comparable index.

The rationale
From a corporate finance perspective, Microsoft was motivated to issue a convertible simply because it was the lowest-cost form
of capital available its 2.95% senior notes due 2014, issued in May, currently yield 2%, and the company paid about 0.17% on all
CP borrowings during its fiscal third quarter, which ended in March. The three-year CB carries no interest, though obviously there
is the potential cost from dilution.
To offset that cost, Microsoft spent about US$37m to purchase a call spread to increase the effective conversion premium to
US$37.16, a 48% premium its shares have not traded above that level since early 2000. The company paid underwriting fees of
about US$7.5m, a gross spread of just 65bp. Although some banks refused to participate at such a low fee, the investment-grade
like costs were integral to achieving the cost target.
The remaining US$1.1bn will be used to repay short-term borrowings (CP), freeing up capacity to repurchase stock. Entirely
allocated to such a use, the funds would result in the repurchase of about 44m shares, just 0.5% of outstanding. The aim of such
an exercise is not just to buy back stock, but to do so in the most efficient manner that is, at a cost superior to commercial paper.
Microsoft has actively bought back stock and certainly has sufficient liquidity to fund repurchases with cash in the nine months
ended March 31, it spent US$7bn to buy back 250m shares and has US$27.5bn remaining on its authorisation programme. The
CB, however, allowed it to supplement buying power while avoiding any tax liabilities from repatriation of cash held abroad.

The implication
Xilinx, a manufacturer of programmable logic devices, conducted a similar leveraged recapitalisation, share repurchase through
the sale of a 30-year put five CB earlier this month. Of the US$520m raised, the company, rated BBB, spent about US$430m to
repurchase 17.2m shares, about 6% of outstanding, and used most of the remaining proceeds to fund a call spread that increased
the effective conversion premium to 75%, from 20%.
Analysts at Goldman Sachs pointed to both Xilinx and Microsoft as potential harbingers of similar leveraged recapitalisations
through low-cost convertible bonds. There are similarities between early 2007, when Xilinx undertook a similar leveraged
recapitalisation, and the current environment.
One primary difference, they said, is that companies bought back much more expensive stock in 2007, and multiples are 40%
lower today. In 2007 there were 15 other companies within TMT that undertook similar recapitalisations through convertible
bonds.
Microsoft and Xilinx trade at 12.1 and 11.4 times fiscal 2011 earnings. At the upper strike of the call spread, where economic
dilution kicks in, that climbs to 16 and 20 times. Both companies have a June fiscal year-end.
When a firm as smart as Microsoft does a trade where they are able to achieve a negative cost basis, youre going to see other
companies follow suit, said a CB banker.
Goldman identified 21 companies that it believes have the potential to accelerate buy-back programmes in the coming months,
including Cisco Systems, Qualcomm, DirecTV, Dell and Corning.
Since the last round of leveraged buy-backs in 2007 and following Xilinxs most recent transaction, we have heard feedback from
both companies and investors expressing disappointment at the lack of long-term share price momentum for companies that
initiated transactions in the last cycle, Goldman analysts said in a June 6 report.

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