Unpicking Microsoft’s free cash flow

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Good morning. Junk bonds are in a “bloodbath” and last week was a rough ride for the AI trade, so the less we have to worry about this week, the better. Alas, it is of course US midterm elections week. Brace, brace. The good news is that if you like, you can once again get your strategic dogecoin reserves out of Binance, which has restarted withdrawals after that enormous heist. Tell us your strategies for keeping your sense of humour together in midterms week: unhedged@ft.com

Microsoft microscope

Last week, we wrote about how investors in the hyperscalers — Microsoft, Alphabet, Amazon, Meta and Oracle — are suddenly taking the decline in the companies’ free cash flow very seriously. (As, naturally, are the rating agencies — S&P Global cut the outlook on Meta to negative just the other day, citing “significant uncertainty around capex and free operating cash flow”.)

In an age of almost incomprehensibly large AI investments, investors want a little prudence. Below, by way of a reminder, is what the hyperscalers’ free cash flow trajectories look like. (Free cash flow is calculated as operating cash flow minus capital expenditures.)

Microsoft stands out — it appears that, unlike its peers, it is not spending most or all of its cash profits that operations bring in. Correspondingly, Microsoft is the only one of the bunch with positive stock market returns over the last, bruising month:

Investors like to look at free cash flow because metrics like operating profit and net income capture investment spending only through a smoothed measure (depreciation) and do not capture swings in working capital items (such as inventory, receivables and payables) that can dramatically affect a company’s economic position.

Hyperscaler investors are, understandably, focused almost exclusively on the investment just at present. But the working capital bit is important too.

There are higher quality and lower quality sorts of free cash flow. The higher-quality kind reflects the fundamental profitability of the business — its ability to sell things for more than they cost to develop, produce and market. The lower-quality kind reflects the ability of the company to finance its activities on favourable terms. For example, a business might be able to pay its suppliers very slowly, while extracting instant payment from customers, which creates a growing stream of cash so long as sales are expanding. (Amazon was famous for this for a long time.)

This sort of financial engineering is not cheating and the company is admirably transparent about it. It is a source of real cash that can pay bills, be invested or simply collect interest. Indeed, there is a whole class of businesses that do nothing but co-ordinate various pools of capital with different financing arrangements. They are called banks. But free cash flow from financial engineering is often more volatile, less sustainable and harder to scale than cash that flows from profitable non-finance operations. So it should be valued less by investors.

Dave Zion of Zion Research Group thinks that all of Microsoft’s free cash flow comes from financial engineering. He thinks this engineering takes four main forms:

• Stock-based compensation: Tech companies love to pay employees in stock and it is important to remember this is a way to defer expenses — paying for labour delivered today with equity to be delivered later, rather than with cash. In the fiscal year that ended in June, stock-based compensation at Microsoft was $12.4bn, equivalent to nearly 19 per cent of Microsoft’s free cash flow of $67bn.
• Lease capex: When Microsoft purchases an asset — a data centre say — by signing a long-term lease, that turns a single big cash investment into a series of smaller future cash outlays. Zion calculated cash savings from leasing rather than buying outright (netting out the lease payments) accounted for $25.6bn in free cash flow in the last fiscal year.
• Accrued capex: When a company makes an investment — but does not pay for it immediately — it ends up as an account payable, rather than in investing cash flow. This added $19.8bn to Microsoft’s free cash flow last year.
• Capex in ‘other’ investing: Microsoft has a very large accounts receivable asset on its balance sheet. A significant part of this is “related to activities to facilitate the purchase of server components”. Zion thinks that this has to do with Microsoft financing inputs on behalf of the companies that supply its data centres. “We’re assuming that those components will eventually find their way into servers that MSFT purchases, so we’re treating the change in the related other receivables balance as capex instead of an “other” investing cash outflow,” he writes. This was worth another $19.6bn in free cash.

Stock-based compensation: Tech companies love to pay employees in stock and it is important to remember this is a way to defer expenses — paying for labour delivered today with equity to be delivered later, rather than with cash. In the fiscal year that ended in June, stock-based compensation at Microsoft was $12.4bn, equivalent to nearly 19 per cent of Microsoft’s free cash flow of $67bn.

Lease capex: When Microsoft purchases an asset — a data centre say — by signing a long-term lease, that turns a single big cash investment into a series of smaller future cash outlays. Zion calculated cash savings from leasing rather than buying outright (netting out the lease payments) accounted for $25.6bn in free cash flow in the last fiscal year.

Accrued capex: When a company makes an investment — but does not pay for it immediately — it ends up as an account payable, rather than in investing cash flow. This added $19.8bn to Microsoft’s free cash flow last year.

Capex in ‘other’ investing: Microsoft has a very large accounts receivable asset on its balance sheet. A significant part of this is “related to activities to facilitate the purchase of server components”. Zion thinks that this has to do with Microsoft financing inputs on behalf of the companies that supply its data centres. “We’re assuming that those components will eventually find their way into servers that MSFT purchases, so we’re treating the change in the related other receivables balance as capex instead of an “other” investing cash outflow,” he writes. This was worth another $19.6bn in free cash.

The total of these and a few smaller adjustments is $75.3bn last year — more than 100 per cent of the company’s free cash flow. This does not mean that Microsoft is somehow hoodwinking investors. Powerful companies can extract good financial terms from suppliers, customers and investors and these terms have real value. The question is how much? “Companies do financial engineering, people do it. It is what it is. It’s a quality of cash flow check,” Zion told Unhedged. “As an investor, you should understand where the cash flow comes from.”

Microsoft, trading at 25 times forward earnings estimates, is the most richly valued of the hyperscalers. Whether it deserves a premium based on its free cash flow is open to question.

(Armstrong)

Stock-bond correlation, revisited

Fed researchers Canlin Li and Emre Yoldas wrote a note that builds on a question we raised earlier during the Iran war: why have Treasuries stopped functioning as a reliable hedge against the stock market?

At the time, we had touched on a variety of different factors like inflationary concerns and a fall in the convenience yield of Treasuries — the reduced interest rates paid on Treasuries relative to securities of comparable safety, duration and credit quality.

Li and Yoldas offer a hopeful explanation: we haven’t had some kind of fundamental shift, it’s just that the current inflation backdrop and the type of supply shocks we’re going through just haven’t been the types of stresses that fire up bonds’ safe-haven superpowers. In their words (with our emphasis):

. . . when inflationary pressures are rising and output is close to potential, central banks may face a trade-off between supporting growth and maintaining price stability. Adverse supply shocks, particularly those arriving amid above-target inflation, may pose similar challenges as central banks may need to keep policy tight to ensure stability of long-term inflation expectations . . . In these cases, stock and bond prices can fall together . . . The post 2021 deterioration in bonds’ hedging property largely reflects this shift in the economic environment, not necessarily a fundamental change in bond characteristics.

. . . when inflationary pressures are rising and output is close to potential, central banks may face a trade-off between supporting growth and maintaining price stability. Adverse supply shocks, particularly those arriving amid above-target inflation, may pose similar challenges as central banks may need to keep policy tight to ensure stability of long-term inflation expectations . . . In these cases, stock and bond prices can fall together . . . The post 2021 deterioration in bonds’ hedging property largely reflects this shift in the economic environment, not necessarily a fundamental change in bond characteristics.

This also isn’t just an American phenomenon. The researchers point out the switch to a positive stock-bond price correlation in the euro area and the UK (with an even stronger correlation coefficient in the UK than in the US). The reactivity of stocks and yields to inflation news is also much stronger post-2021.

The implication here is that if inflation eases and adverse supply shocks become less frequent, the stock-bond relationship will revert to what we consider to be normal. But it’s hard to ignore the other factors that haven’t been mentioned — such as concerns surrounding the US’s fiscal health and President Donald Trump’s policy credibility — that could persist even after inflation cools and could also force stocks and bonds to move together, eg “liberation day”.

There are a lot of other forces that persist that we think will have investors demanding a higher yield on Treasuries, even after inflation moderates.

(Kim)

One good read

“This has always been the play”

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