Microsoft (MSFT) is one of only two companies to hold the coveted AAA credit rating from Standard & Poor’s. The other is Johnson & Johnson (JNJ).

This stellar credit rating is a testament to the strength and stability of Microsoft’s business model. Microsoft has delivered incredible total returns over the years, and made Bill Gates (one of its founders) a billionaire many times over. He is the richest man in the world and you can see his holdings here.

With fifteen years of consecutive dividend increases, Microsoft is also a member of the Dividend Achievers – a group of companies with 10+ years of consecutive dividend increases.

You can see the list of all 272 Dividend Achievers here.

To get a sense of how rare Microsoft’s AAA credit rating is, read the introduction of this article which discusses Johnson & Johnson’s creditworthiness.

To summarize, Microsoft’s AAA rating means that the company is considered more creditworthy than the federal government, all but 15 states, and all but 1 other company.

Think about that… Microsoft is seen as a better debtor than the U.S. Federal Government, which has the ability to tax domestic citizens. Clearly Microsoft is a remarkable company.

This post will discuss the many reasons why Microsoft holds a perfect credit score from S&P.

Microsoft – Business Overview

Microsoft is a diversified technology company. Many of their products, including Windows and Microsoft Office, have become staples in the world of personal computing.

Microsoft’s business is split into three segments for reporting purposes, listed below.

  • Productivity & Business Processes (31% of YTD revenues)
  • Intelligent Cloud (28% of YTD revenues)
  • More Personal Computing (49% of YTD revenues)

Note that the segment revenues listed above do not add to 100% because of 8% expenses not assigned to any particular segment (instead labelled as Corporate and Other).

In order to determine why this company holds S&P’s highest credit rating, we will begin by investigating the company’s balance sheet.

Examining Microsoft’s Balance Sheet

Microsoft went a long time before issuing its first corporate bonds. Microsoft’s first foray into the public debt markets occurred in 2009 with a $3.75 billion debt offering.

Since then, the company’s long-term debt has been slowly increasing, as has its ratio of long-term debt to shareholders’ equity. Both levels have remained reasonable given the growing size of the company.

These trends can be seen below.

Microsoft

Source: Value Line

For comparison, I’ve created a graph of long-term debt to shareholders’ equity for the following mature technology companies that are seen as peers to Microsoft:

The leverage levels of these companies over time can be seen below.

Microsoft

Source: Value Line

After looking at the above graph, it might not be immediately obvious why Microsoft sports a AAA credit rating. Microsoft does not maintain a noticeably lower leverage level than its peers (IBM aside).

For more insight, it might be helpful to look at the absolute levels of debt that these companies maintain. The long-term debt levels of this peer group can be seen in the following diagram.

Microsoft

Source: Value Line

Interestingly, Facebook had actually paid off all of their long-term debt before the end of fiscal 2016. As it sits right now, Facebook has no long-term debt.

This might suggest that Facebook is more creditworthy than Microsoft, since the companies are of roughly the same size, operating in the same industry, but Microsoft has debt and Facebook does not.

Clearly, leverage does not tell the whole story, or Facebook would likely also hold the coveted AAA credit rating. There are other factors that affect Microsoft’s ability to repay debt.

For instance, Microsoft’s creditworthiness benefits from its extremely large cash hoard. As of the second quarter of fiscal 2017, Microsoft reported $8.5 billion of cash and cash equivalents and $114.3 billion of short-term investments on the company’s balance sheet.

Together, these combine for $122.8 billion of cash, cash equivalents, and short-term investments, which equates to $15.68 on a per-share basis. This is based on 7.83 billion diluted shares outstanding listed on the company’s income statement.

Considering that Microsoft’s current stock price is ~$65, this means that approximately one-quarter of the company’s per-share market value can be found in cash, cash equivalents, and short-term investments.

This provides Microsoft with considerable liquidity, which contributes to their perfect credit rating.

Microsoft’s Premium Earnings Mix and Product Portfolio

Another factor that improves Microsoft’s creditworthiness is the nature of their product offerings.

Many businesses would not be able to function properly without the use of Microsoft products like Word, Excel, and Outlook. Further, many homes would lose much of their functionality (in terms of communication, eCommerce, etc.) without the personal computing capabilities provided by the Windows operating system.

This is in contrast with other technology companies like Facebook, whose products are used purely for pleasure. Since Facebook’s revenues are more discretionary in nature, the company’s revenues would likely decline more in a period of economic recession compared to Microsoft.

This inelastic demand for Microsoft’s products is noted by the ratings agencies. In a 2016 credit update on the company, S&P said:

The company has a diverse software and hardware product portfolio and a long track record of maintaining leadership in its Office and Windows operating systems, leading to significant free operating cash flow to meet its acquisition and shareholder return needs. The company’s long history of making investment and acquisition decisions in a fiscally prudent manner is a positive factor in determining its credit quality, and we expect that to continue.

Microsoft’s necessity-based products have led the company on a steady streak of earnings-per-share increases. The company’s bottom line growth since 2000 can be seen below.

Microsoft

Source: Value Line

Microsoft’s strong record of earnings-per-share increases helps the company to hold their AAA credit rating. Since Microsoft has shown the ability to boost earnings through a variety of market conditions, creditors need not be concerned that the company will default during a recession.

Final Thoughts

Microsoft is a high-quality company whose products are used every day by millions of people. Their low leverage levels, large cash hoard, and necessity-based business model are all contributors to the company’s perfect credit rating from S&P.

Microsoft is also a strong dividend payer, with 15 consecutive years of rising dividend payments. The company is a Dividend Achiever and will likely be one of the next great Dividend Aristocrats.

However, since the company does not have 25+ years of steady or rising dividends, it is not included in the Sure Dividend system. It would likely rank highly using the 8 Rules of Dividend Investing if it were.

Long-term investors should keep an eye on this AAA-rated company.

Article by Nicholas McCullum, Sure Dividend