Does Big Borrowing Maximize Value?

When sources reported that Microsoft (Nasdaq: MSFT  ) was mulling a debt offering to launch a massive share buyback program and possible dividend increase, tongues started wagging that this was a smart, strategic move. It wouldn't borrow so much that it would jeopardize its AAA credit rating. But that got me thinking: Does borrowing money to fund share repurchases and dividend payments really make sense?

Robbing Peter to pay Paul?
With interest rates as low as they are, debt is a pretty attractive investment right now. Home Depot (NYSE: HD  ) and Dell (Nasdaq: DELL  ) just finished issuing bonds this month, and according to an analysis by Thomson Reuters, corporations issued $33.7 billion in investment grade debt for the week ending Sept. 10 -- a two-year high -- with Hewlett-Packard (NYSE: HPQ  ) the biggest issuer at $3 billion. American Express (NYSE: AXP  ) doubled the size of its planned offering to $2 billion.

Reports suggest that Microsoft could raise as much as $6 billion without impacting its credit rating.

The taxman cometh
There are definitely good reasons for taking on debt for various corporate purposes, even buying back stock or paying dividends. A company like Microsoft that's sitting on nearly $37 billion in cash certainly has the wherewithal to finance its debt, and with the tax benefits that come from servicing the debt, it could even improve its overall financial position.

Moreover, with much of Microsoft's money residing overseas, repatriating it might actually cost the company more in taxes than it would to just tap the bond markets.

Do as I say, not as I do
Where the problems arise is when this mind-set trickles down to less financially secure companies and they succumb to the temptation to take on debt too. Facing pressure from shareholders to "return value," these riskier businesses will lard their balance sheets with debt making it harder for them to maneuver should that dreaded double-dip recession materialize.

Right now, there are a number of encouraging signs that we might be able to whistle past the graveyard on renewed economic contraction (hey, you heard the recession ended last year, right?), but there are equally ominous warnings that difficult times are still ahead. Remember, companies don't get into trouble because they have too much cash in the bank; it's when they burden themselves with debt that fault lines are revealed.

And boy, do we have debt! The consensus view is that companies are sitting on piles of cash that they're reluctant to deploy. The Federal Reserve reported that nonfinancial companies had built up $1.84 trillion in cash by the end of March, 26% higher than last year and the largest increase ever going all the way back to 1952 when they first started tracking such things.

That has pushed companies toward paying dividends. Earlier this year, Target (NYSE: TGT  ) boosted its dividend 47% because its cash holdings were "well above the amount needed for optimal reinvestment in our core business." And Cisco (Nasdaq: CSCO  ) said with more than $39 billion of cash burning a hole in CEO John Chambers pocket, it wanted to initiate a dividend yielding 1% or 2% by the end of the company's current fiscal year.

Choking for air
Yet if you're only looking at the asset side of the corporate ledger, you're missing a huge part of the whole picture. On the liabilities side, corporate debt has bloomed like algae on an oxygen-starved pond.

The Federal Reserve also reported that domestic debt levels at non-financial companies soared to $7.26 trillion at the end of the first quarter, also the highest level ever. No wonder companies are flush with cash: just like consumers, corporations are filling their coffers by maxing out their credit lines.

Maybe they just want to raise cash while they're still able. With cash very easy to come by, these corporations are gettin' while the gettin's good. A Bloomberg analysis says industrial and consumer companies are paying down their loans, while tech, energy, and utility stocks are boosting their borrowings to record levels.

But companies are quickly becoming less liquid as they do so giving them little room to move if the economy sours. And buying back shares or paying out dividends with borrowed money is an artificial means of redistributing cash to shareholders and raising earnings per share. Like a stock split, it doesn't change the underlying operations of the business in any meaningful way.

Moving the goalposts closer
Let's also not forget that many executive compensation schemes are based on making their EPS goals. Reducing share counts is one of the easier methods of hitting those marks.

A company like Microsoft can afford to take on more debt. Investors would be wise to look at their own company' balance sheets and see who else is piling up the debt and what that will mean for them if the markets turn south once again. It's likely that mortgaging their future won't be such a good financial plan.

American Express, Home Depot, and Microsoft are Motley Fool Inside Value recommendations. The Fool has a bull call spread position on Cisco Systems. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Microsoft. Try any of our Foolish newsletter services free for 30 days.

True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool has a disclosure policy.

Fool contributor Rich Duprey does not have a financial position in any of the stocks mentioned in this article. You can see his holdings here. The Motley Fool has a disclosure policy.


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