Fitch Places Microsoft (MSFT) Ratings on Review for Downgrade Amid LinkedIn (LNKD) Deal

Fitch Ratings has placed the long-term ratings for Microsoft Corporation (Nasdaq: MSFT), including the 'AA+' Issuer Default Rating (IDR), on Rating Watch Negative following the announcement Microsoft will buy LinkedIn Corp. (LinkedIn) for $26.2 billion. Fitch affirms the short-term ratings at 'F1+'. Fitch's actions affect $56.4 billion of total debt, including the indrawn $10 billion revolving credit facility (RCF). A full list of Fitch's rating actions follows at the end of this release.

The Rating Watch Negative reflects Fitch's expectation for structurally higher leverage, given Microsoft's intention to fund the LinkedIn acquisition primarily with new debt. Fitch estimates Supplemental Adjusted Net Leverage, which offsets debt with a portion of Microsoft's $106 billion of offshore cash (at March 31, 2016), will approach 1.5x, pro forma for the deal and Fitch's expectations Microsoft will continue borrowing to fund shareholder returns, given the majority of Microsoft's free cash flow (FCF) is outside the U.S. This compares to Fitch's previous expectations Supplemental Adjusted Net Leverage would remain below 1x through the intermediate term. Fitch expects to resolve the Rating Watch Negative upon greater clarity on the ultimate amount of debt issued to fund the LinkedIn transaction and expectations for debt financed shareholder returns beyond the near term.

The company reiterated its commitment to complete the current $40 billion share repurchase authorization, of which roughly $10 billion remains available for repurchase, by the end of calendar 2016. Fitch also assumes Microsoft will continue using 100% of annual FCF for shareholder returns, consistent with the company's stated focus on balancing high priority investments with returning cash to shareholders. Given Fitch's expectations for more than $10 billion of annual FCF, debt could increase $5 billion to $10 billion per year.

Fitch expects the acquisition of LinkedIn will accelerate top line growth through at least the intermediate term. Fitch expects LinkedIn's revenues will grow 25% in calendar 2016 to $3.7 billion, up from $3 billion for 2015. Operating EBITDA should approach $1 billion in 2016, versus a Fitch estimated $780 million for 2015. Microsoft expects to achieve $150 million of run rate cost synergies exiting fiscal 2017, from the elimination of redundancies.

In addition to acquiring LinkedIn's more than $2 billion Talent Solutions and $300 million Sponsored Businesses Updates, Fitch views the acquisition as enrichening Microsoft's productivity tools and cloud with LinkedIn's professional network. Microsoft plans on driving increased engagement across LinkedIn, Office 365 and Dynamics to accelerate monetization through subscriptions and targeted advertising. Nonetheless, Fitch expects the combination will do more to strengthen Microsoft's existing connections with customer than create meaningful incremental demand.

Microsoft announced on June 13, 2016 it entered into a definitive agreement to acquire LinkedIn in an all-cash transaction for $196 per share, valuing the company at $26.2 billion (27x Fitch's forecasted 2016 operating EBITDA) including LinkedIn's net cash. Microsoft plans on funding the transaction primarily with new debt; given nearly all the company's cash is located outside the U.S. The deal was approved by both companies' Boards of Directors, including LinkedIn's founder and largest shareholder, and is subject to customary regulatory approvals. Microsoft expects to complete the acquisition by the end of calendar year 2016.

KEY RATING DRIVERS

The ratings and Rating Watch reflect:

Fitch's expectation operating performance will remain solid, driven by robust cloud services growth. Fitch expects Microsoft to remain a leading cloud services provider over the intermediate term, driven by a significant Windows operating system (OS) footprint and competitive advantage in the hybrid cloud. Overall, Fitch projects flat top line growth in fiscal 2016 and low single digit positive revenue growth over the intermediate term, despite continued revenue declines in the 'More Personal Computing' segment.

Fitch also expects cloud services growth to diversify Microsoft's significant revenue base and increases profitability while reducing the company's dependence on personal computers (PCs). While Microsoft's 'More Personal Computing' segment still represents more than 40% of revenues, it constitutes roughly a third of operating profit. Fitch expects significant incremental gross profit will stem profit margin compression in 2016 and return operating EBITDA margin to above 40% over the intermediate term.

Fitch expects positive growth and strong profitability will result in more than $10 billion of annual FCF (calculated by Fitch after payment of dividends), which should continue through the intermediate term. Fitch expects Microsoft will use a substantial amount of FCF for share repurchases, including completing the current $40 billion share repurchase program, by the end of calendar year 2016. Beyond the completion of the current authorization, Fitch projects shareholder returns equal to annual FCF.

As a consequence, Fitch expects total leverage (total debt to operating EBITDA) to step up over the intermediate term from significant incremental debt issuance to support shareholder returns, given the vast majority of Microsoft's cash and more than half of FCF is outside the U.S. Fitch estimates total leverage for the latest 12 months (LTM) ended March 31, 2016, was 1.4x and should exceed 2x over the intermediate term. Fitch estimates Supplemental Net Adjusted Leverage, could approach 1.5x, versus previous expectations of below 1x.

Fitch believes Microsoft's nearly ubiquitous OS provides substantial recurring revenues and cash flow, despite ongoing declines in PC shipments, which Fitch expects could decline in the high single digits in 2016. Nonetheless, Fitch believes Microsoft's scale and visibility of profitability are enabling investments in growing cloud services and connected devices, diversifying the company's operating profile.

KEY ASSUMPTIONS
--Fitch expects flat organic top line growth in fiscal 2016 with strong Intelligent Cloud penetration offsetting continued negative PC growth. Phones will remain challenged but potentially offset by solid detachable (Surface Pro) adoption. Fitch believes currency will reduce the top line by 2%, resulting in -2% revenue growth for the fiscal year.
--Beyond fiscal 2016, Fitch believes the increasing Intelligent Cloud growth will shift mix and drive positive low single digit growth through the forecast period.
--Gross profit margins will be stable from shifting the mix away from PCs, despite modest competition-driven pressure on cloud businesses.
--Fitch believes operating margins will strengthen from R&D leverage in the business.
--Capital spending will remain elevated to support investments in Intelligent Cloud.
--The company will ratably complete the remaining $10 billion of share repurchases under the current authorization by the end of calendar 2016.
--Annual dividend growth will be 10% and share repurchases will equal 100% of FCF.
--Microsoft will refinance maturing debt and issue incremental debt to fund domestic cash shortfalls.

RATING SENSITIVITIES
Negative: Future developments that may, individually or collectively, lead to negative rating action include:

--The expectation for Supplemental Adjusted Net Leverage (total debt netted against adjusted cash and investments held outside the U.S.) will remain above 1.5x from significant debt issuance to support the LinkedIn acquisition and ongoing shareholder returns.
--Material profit margin erosion related competitive pressures, including strong commercial adoption of the public cloud and/or open-sourced software materially reduces demand for key Microsoft products; penetration of alternative operating systems in the PC market or market share gains by Apple; or greater acceptance of cheaper software applications that compete with Microsoft Office.

The Rating Watch Negative could be resolved and current long-term ratings affirmed at 'AA+' if Fitch expects Supplemental Adjusted Net Leverage will remain below 1.5x, likely from:
--Microsoft's use of cash to fund a meaningful portion of LinkedIn;
--Lower than expected ongoing shareholder returns; or
--Greater than anticipated revenue synergies from the acquisition of LinkedIn, resulting in meaningful operating EBITDA growth.

LIQUIDITY
As of March 31, 2016, Fitch believes liquidity was robust and supported by:

--$105.6 billion of cash and short-term investments, of which $2.8 billion was located in the U.S.;
--Two undrawn $5 billion revolving credit facilities (RCF), one expiring Nov. 1, 2016 and the other expiring Nov. 14, 2018, both of which backstop the company's commercial paper (CP) program.

Fitch's expectation of more than $10 billion of annual FCF also supports liquidity.

Total debt as of March 31, 2016 was $46.4 billion, consisting of staggered debt maturities. Fitch believes debt maturities are manageable, given the company's strong liquidity and consistent FCF. However, Fitch expects Microsoft will refinance all debt maturities, given the company's bias toward using domestic cash for shareholder returns.

FULL LIST OF RATING ACTIONS

Fitch has placed the following ratings on Rating Watch Negative:

Microsoft
--Long-Term IDR 'AA+';
--Senior unsecured debt 'AA+';
--Senior unsecured revolving credit facility 'AA+'.

Fitch has affirmed the following ratings:
--Short-Term IDR at 'F1+';
--Commercial paper at 'F1+'.

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