Salesforce issues $25 billion in bonds to buy back stock. Should I be worried?

Salesforce announced this week that it has executed the first phase of a $25 billion debt-fueled stock repurchase acceleration plan. This is half of the $50 billion buyback authorization approved in February.

Raising debt to buy back stock is a move that deserves scrutiny.

After all, equity carries no financial obligations or the consequences of issuing debt. If a company does not pay dividends on its stock, the company will not perform well and its stock price will suffer. However, there are no legal consequences or claims. If a company defaults on its debts, it faces legal issues and claims from bondholders.

We know why Salesforce would want to buy back its own stock. Management believes last month’s brutal sell-off due to concerns about AI disruption makes the stock attractive. That’s because, as CEO Marc Benioff said in a press release Monday, “We are extremely confident in the future of Salesforce.” (Salesforce insiders are also buying, including board members and williams sonoma CEO Laura Alber bought about $500,000 worth of Salesforce stock on Thursday, as did fellow director and former chief scientist David Kirk. Nvidiaacquired about $500,000 worth of Salesforce stock on Wednesday).

So why would Salesforce issue bonds to buy back stock? Part of that may be because Benioff and the company want to conserve cash. But primarily, it comes down to the cost of equity and the cost of debt. CNBC Investing Club reporter Paulina Likos and I actually briefly touched on this concept in a recent video on discounted cash flow valuation modeling. Although this video focuses on terminal value, it also covers the concept of discount rate, or the required rate of return that an investor demands on an investment in a particular security. We noted that retail investors can and should use the interest rate they deem appropriate for the risk they are considering.

However, for Wall Street companies, the discount rate is often their “weighted average cost of capital” (WACC). WACC is the weighted average of the cost of debt and cost of equity needed to finance a company.

breakdown:

V = Total value is the sum of equity and debt E = Market value of equity (E/V is the weight of equity in the capital structure) D = Market value of debt (D/V is the weight of debt in the capital structure) Ce = Cost of equity Cd = Cost of debt T = Corporate tax rate

You don’t need to worry too much about this calculation method. The real objective is to consider what goes into the equation to better understand how companies think about achieving the most efficient capital structure, i.e. the lowest possible WACC. The lower the discount rate (WACC in this case), the higher the present value of future earnings and cash flows. Bottom line: Increasing the weight of lower priced assets (equity or debt) can lower WACC. That is, the period during which investors begin to worry about balance sheet leverage and express that concern by demanding higher returns on equity, causing stock prices to fall and companies’ cost of equity to rise.

So which is lower for Salesforce, the cost of equity or the cost of debt? Now that we’ve told you the yield that Salesforce is paying on its bonds, it’s pretty easy to figure out the debt part. That is what is shown on the next slide.

Returning to the WACC formula above, the cost of debt is multiplied by 1 minus the tax rate to reflect that the company receives a tax deduction for debt interest payments. Therefore, the actual cost of debt will be lower than the cost shown on the slide. Don’t worry about how low it is. Please know that, based on WACC calculations, the true cost of debt is the yield above multiplied by a number less than 1. So at the highest level, for bonds maturing in 2066, Salesforce’s pre-tax cost would be about 6.7%, and the after-tax cost of any debt below that. Assuming a 22% corporate tax rate, it’s probably closer to about 5.3%.

Now that we know what the most expensive part of this debt financing will cost Salesforce, let’s calculate what our cost of equity will be. To do this, the Capital Asset Pricing Model (CAPM) is used. The calculation is as follows:

breakdown:

Rf = risk-free rate — a commonly used representative value is the 10-year Treasury yield β = beta — a measure of systemic risk, the volatility of the stock price relative to the index Rm = expected market return (Rm – Rf is the calculation of the market risk premium)

There is an equation to find beta. However, most data providers already have it in place. Rather than doing the calculations ourselves, we obtained beta input for Salesforce from FactSet. So, given Salesforce’s 3-year beta of 1.21, 10-year Treasury yield of 4.24% (as of this writing), and a conservative expected market return of 8%, Salesforce’s cost of equity is approximately 9.27%. Because the cost of capital is much higher than the cost of debt, exchanging equity for debt lowers Salesforce’s weighted average cost of capital.

It’s natural to question Salesforce’s stock buybacks because of debt, since it would take on new financial obligations at a time when the company claims AI makes its long-term outlook difficult. But from the perspective of management, who are clearly not concerned with long-term fundamentals, strengthening the company’s capital structure by lowering its total cost of capital is a wise move. A low WACC not only lowers the discount rate in Wall Street financial models and increases present value, but also opens up more investment opportunities by lowering the hurdle to generating positive returns.

This move may make sense, but only time will tell if it is wise. Salesforce is trading out the arbitrariness of its balance sheet to reduce its stock count and boost its earnings per share. However, this strategy also lowers its credit rating by S&P Global as it increases balance sheet leverage. That means future debt costs will be higher.

It all depends on whether Salesforce can pay off its debts, which will likely come down to who’s right in the AI ​​debate. If Salesforce is indeed replaced by a successor like Claude (which we don’t think will happen, but the market is clearly concerned), debt service will become even more difficult, investors will be more concerned now that the company has a stronger balance sheet, and the stock price will likely fall. As a result, all this is not only a complete waste of money, but also a financial anchor. On the other hand, if management proves to be correct and Salesforce grows from this and actually benefits from AI, this move will strengthen the company’s capital structure.

While weak credit ratings remain a concern, if all goes well, this situation can be reversed as management can pay down debt, deleverage balance sheets, and improve overall financial credibility. The move would also increase compensation if the bulls prove correct by ensuring that all shareholders own a little more of the company than before thanks to the retirement of shares bought back by this debt.

(Jim Cramer’s Charitable Trust is a long CRM. See the complete list of stocks here.)

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