Microsoft hedging strategy could carry big price tag
By Scott Hillis
SEATTLE, Oct 10 (Reuters) - A fancy and so-far lucrative hedging scheme that has put more than $2 billion in the coffers of Microsoft Corp. <MSFT.O> could cost the software giant plenty if its share price fails to rally out of its recent slump, analysts said on Tuesday.
Under the hedging strategy, Microsoft sells "put warrants" on its shares to investment houses. The warrants give the buyer the right to sell Microsoft shares back to the company on a certain date at a predetermined price.
Microsoft says it has pocketed more than $2.1 billion in premiums from selling the warrants, and as long as its stock rises above the preset price, the instruments eventually expire worthless and the company owes nothing.
But with Microsoft stock mired at its lowest levels in two years -- $54-9/16 on Tuesday, down from a high of $119-15/16 in December -- the Redmond, Wash.-based company could be forced to start buying those shares at above-market prices if the stock doesn't recover.
In its annual report sent out late last month, Microsoft said that as of June 30 there were warrants on 157 million shares with strike prices between $70 and $78 per share. The warrants expire between September 2000 and December 2002.
The value of the shares at the average price of $74 each is more than $11 billion.
"It was a way for them to get cash in the door to buy back their own stock," said Scott McAdams, president of McAdams Wright Ragen, a Seattle-based brokerage.
Microsoft has granted its employees hundreds of millions of shares of stock options, which when exercised add to the total pool of outstanding shares, meaning that key metrics like earnings per share can suffer. Microsoft buys back shares to try to keep such dilution in check.
"When you sell a warrant you bring in cash. You're taking that incremental cash and going back and buying back your stock, which they were doing anyway to dilute the exercise of stock options," McAdams said.
"If you're bullish on your stock, which these guys were at the time, it's a way to get free cash. It's a smart move when your stock does in fact go up," McAdams said.
Microsoft said it benefits either way. If the stock rises, Microsoft pays the warrant holders nothing. If it is forced to buy the stock, it can then retire those shares and keep a lid on the number of shares outstanding as employees cash in their options, spokeswoman Katy Fonner said.
"It's a good thing because it works both ways. Microsoft takes in a premium for these puts but if the puts are put back to company it's not necessarily a bad thing," Fonner said, adding that the strike prices were set at levels that Microsoft could stomach if it was forced to buy the shares.
The warrant strategy was started under Microsoft's previous share buyback program that ended in January. Microsoft started another repurchase program in August, but Fonner declined to say whether put warrants were being used under the new plan.
The cost could be less than appears at first blush, McAdams said. One way Microsoft can settle the warrants is to simply pay cash for the difference between the strike price and the market price, McAdams said.
So if the stock stays at $55 a share, and the average strike price is $74 dollars, Microsoft would owe $19 times 157 million shares, or just under $3 billion.
Fonner said any deal like that wouldn't affect Microsoft's bottom line because the company would simply dip into its legendary cash pile -- estimated now at about $23 billion -- to cover any costs.
"None of the transactions ever effect the income statement, they only affect the balance sheet," Fonner said.
17:35 10-10-00
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