Microsoft (MSFT): A High Quality Dividend Growth Stock in Tech

Microsoft (MSFT) is a company legendary for making many investors very wealthy over the decades.

 

In fact, Bill Gates’ dividend stock portfolio would not exist if it weren’t for Microsoft’s incredible growth story.

 

Over the past 14 years the company has become a favorite among many dividend investors, thanks to its dividend achiever status and 15% annual payout growth rate over the last decade.

 

Let’s take a closer look at Microsoft’s business, including the important ways that management is pivoting the company to take advantage of the disruptive technology of the future.

 

Most importantly, learn if Microsoft’s strategy is likely to make it a solid long-term core holding for diversified dividend growth portfolios, such as our Top 20 Dividend Stocks portfolio.

 

Business Overview

Founded in 1975 in Redmond, Washington, Microsoft is most famous for its Windows operating system, which runs approximately 87% of the world’s computers.

 

However, in recent decades the company has vastly diversified its operations to become a software and hardware powerhouse, operating in over 190 countries around the globe.

 

Microsoft now operates three distinct business segments:

 

Productivity and Business Processes: Office 365 commercial and consumer product suites, which include Office, Exchange, Outlook.com, Skype, and OneDrive cloud solutions for businesses and individuals.

 

Intelligent Cloud Services: Server and cloud based solutions, including its fast-growing Azure business cloud platform.

 

Personal Computing: Traditional Windows business on PCs, as well as Xbox gaming platform, and Bing search engine.

 

As you can see below, Microsoft’s legacy personal computing business remained the dominant revenue driver in 2016.

 

However, the company’s faster-growing business productivity and intelligent cloud businesses were the big cash cows when it came to operating profits.

 

These segments earn higher margins because they are less commoditized and provide higher value. They will be the most important dividend growth for the company going forward.

 

Business Segment	2016 Revenue	% of Revenue	% of Operating Income
Productivity & Business Processes	$26.5 billion	31.0%	61.7%
Intelligent Cloud Services	$25.0 billion	29.4%	46.4%
Personal Computing	$40.5 billion	47.4%	30.43%
Corporate	-$6.7 billion	-7.8%	-38.4%
Total	$85.3 billion	100%	100%

Source: 2016 Annual Report

 

 

Business Analysis

In recent years, Microsoft has struggled with declining sales and stagnant free cash flow.

 

 

Worse yet, margins and returns on shareholder capital have also deteriorated over the last five years.

 

 

So then why is Microsoft’s stock trading at all-time highs?

 

The answer is that new CEO (since February 2014) Satya Nadella’s “mobile first, cloud first” turnaround is finally starting to bear fruit, with gross margins rising strongly across all of its business units in the past quarter.

 

Equally important, sales growth has turned positive after declining for five consecutive quarters from late 2015 through 2016.

 

 

The company’s improvement is due to two main factors. First, Microsoft has been incredibly successful in winning market share for its Azure cloud services business.

 

In fact, Azure’s revenues have been about doubling year-over-year in recent quarters.

 

Meanwhile, Azure Premium recently recorded its 10th consecutive quarter of triple digit (100+%) growth.

 

Analysts think that Microsoft will be able to achieve massive economies of scale in cloud computing that will eventually allow operating margins to hit at least 30% from this fast-growing cash flow stream.

 

In fact, on an annualized basis Azure is now bringing in $14 billion per year in recurring, high margin revenue.

 

Management expects Azure’s recurring revenue to hit $20 billion by 2018 (19.5% annualized growth), which when combined with Microsoft’s other recent successes, should make for solid growth on the company’s top and bottom lines.

 

Microsoft’s business model is also undergoing a shift from one-time software license sales, such as software preloaded onto PCs, towards a subscription-based revenue stream where users continuously pay on a monthly or annual basis.

 

While this reduces the initial amount of revenue Microsoft can recognize, the company will likely enjoy a higher customer lifetime value and more stable cash flow as it gains more subscribers.

 

Since the marginal cost of these products is zero, continued growth in the subscriber base should drive continued improvement in Microsoft’s margins.

 

Office 365 subscribers (consumer and commercial versions) are growing between 20% and 40% annually in recent quarters, indicating that the future remains bright for this business.

 

Even Microsoft’s PC-dependent Windows operating system business, which suffers from a secular decline in PCs as the world transitions to mobile computing platforms, is doing relatively well.

 

For example, in the past year PC OEM sales have stabilized and started growing again at a moderate pace.

 

Meanwhile, Microsoft’s video game business is flourishing with steadily rising gaming revenue, courtesy of growth in its Xbox Live subscription service.

 

And that’s not even counting the 2017 launch of Microsoft’s $300 virtual reality headset, which could provide a boost to gaming hardware sales.

 

In fact, 2017 should be another good year for the Xbox division because Microsoft recently announced a new subscription service called Xbox Game Pass.

 

 

This $10 per month service allows gamers to get access to some of the most popular older gaming titles, at a 20% discount to rivals such as Gamestop (GME).

 

In other words, Microsoft is trying to monetize more of the gaming market, as well as lock in users to its highly profitable, recurring revenue business model. If successful, Microsoft will enjoy higher future cash flow it can use to help grow its dividend.

 

Microsoft has a number of future tech opportunities as well, which provide a potentially long growth runway.

 

For example, the company’s controversial $26.2 billion acquisition of LinkedIn last year means that the company could incorporate the world’s premier business social network (one that HR departments are increasingly turning to for new hires) into its existing business service suite.

 

Meanwhile, Microsoft continues to copy successful competitors such as Slack, recently announcing that it’s planning on launching a competitor called Skype Teams. This service will be bundled into its Office 365 enterprise services.

 

Compared to Slack’s monthly plans, Microsoft’s offerings will not just offer similar price points, but because they also include Office 365 services, they create a better value proposition that should only help to increase the subscriber growth rate and retention rates.

 

There’s also meaningful potential for Microsoft to benefit from one of the largest developing mega-trends of the 21st century – autonomous cars.

 

That’s because analyst firm IHS estimates that global sales of driverless cars could reach 21 million vehicles per year by 2035 (up from an estimated 600,000 autonomous vehicles sold in 2025).

 

How does this benefit Microsoft? Each driverless car generates an incredible amount of data that needs to be stored in the cloud.

 

For example, in 2017 alone, a regular car that’s merely connected to the internet and driven two hours per day generates 20 GB of data per day.

 

In contrast, an autonomous car generates 10 GB per second when it’s in self-driving mode, thanks to the presence of numerous cameras, nearly two dozen sensors, and over 20 onboard computers.

 

In the coming years and decades, the sheer amount of data coming from just self-driving cars could be an order of magnitude more than all of the world’s current data generation.

 

Since Microsoft’s Azure cloud computing platform is the second largest in the world, the rise of self-driving cars could mean strong and profitable growth for decades to come.

 

Renault-Nissan has already signed on with Microsoft to use its Azure cloud platform to test the company’s autonomous cars, as has Reinsurer Swiss Re, who will use Azure to monitor telematics data from cars to better analyze accidents for use in insurance claims.

 

Meanwhile, Microsoft is spending billions of dollars on R&D in areas such as artificial intelligence and machine learning to continue making Azure more competitive with major rivals such as Amazon (AMZN) Web Services.

 

Machine learning is basically software that teaches itself, and thus quickly becomes more efficient and better at parsing the mountains of data that are being generated by an increasingly mobile connected world via the explosive growth of smartphones, the internet of things (IOT), and driverless cars.

 

Artificial intelligence isn’t the only thing working in Azure’s favor.

 

Microsoft recently announced it plans to invest $1 billion a year (8% of 2016’s R&D budget) into cyber security, and that doesn’t include potential acquisitions.

 

As the world’s technology becomes ever more connected, including things like mobile payments, cyber security is only going to become more important and valuable.

 

Cyber security represents yet another opportunity for Microsoft to create a holistic and integrated cloud computing solution for the world’s companies and governments to meet their fast-growing data storage, analytics, and security needs.

 

Simply put, Microsoft’s CEO has shifted the company into more reliable sources of recurring revenue while gradually diversifying it away from a stagnant PC operating system business and into a number of areas that have potential to deliver much stronger growth and higher profitability over the coming years.

 

Key Risks

While Microsoft’s potential growth runway is highly diversified and large in size, nonetheless there are several risks to consider.

 

First is the massive competition the company faces in all of its major growth fields.

 

For example, Azure, the company’s cloud computing platform, is by far the most important sales, earnings, and FCF driver.

 

While Azure currently holds an impressive 28.4% market share (see below), second only to Amazon Web Services, Microsoft will have to stay on its toes if it hopes to maintain or even grow that share against massively well-capitalized rivals such as Amazon or Alphabet (GOOG).

 

 

Similarly, while the total addressable market (TAM) for Microsoft’s recurring revenue focused enterprise productivity services is enormous (potentially enough to double the company’s sales over the next 10-15 years), the company faces serious competition from rivals such as Salesforce.com (CRM) and Oracle (ORCL).

 

 

And while cyber security seems likely to be one of the hottest growth markets in coming years, let’s not forget that tech giant Cisco Systems (CSCO) has also set its sights on becoming a leader in that industry.

 

Microsoft’s recent moves, including heavy investments into artificial intelligence, cyber security, and driverless cars, do help set its service apart from rivals.

 

Microsoft also continues to expand the utility of its productivity suites, which should make its Office 365 ecosystem even stickier over time.

 

However, the risk is that its major rivals are all attempting to follow similar strategies that could force Microsoft into a price war that puts pressure on its margins over time.

 

Many secular trends, such as self-driving vehicles, could also take much longer to develop than investors expect.

 

Next is the risk that major acquisitions, such as 2016’s purchase of LinkedIn, might not work out as well as the company hopes.

 

After all, under former CEO Steve Ballmer, Microsoft was notorious for lighting shareholder money on fire via ill-conceived mega-deals, such as purchasing aQuantive for $7.2 billion in 2007 and paying $7.4 billion for Nokia in 2014.

 

The company later wrote both purchases off as a complete loss.

 

While Satya Nadella’s visionary strategy for the company seems, at least thus far, superior to Ballmer’s “grow at all costs” approach, it will be a while before we know if LinkedIn can indeed live up to its potential.

 

For example, Microsoft is expecting LinkedIn to provide over $4 billion in sales in 2017 with double-digit growth for years to come.

 

The deal could turn out to be a brilliant capital allocation move or yet another dud, depending on how quickly LinkedIn continues to grow. Only time will tell.

 

Another risk is Microsoft’s increasing amount of debt, which the company has used to help fund its shareholder capital returns.

 

While that is understandable, given that the vast majority of Microsoft’s cash flow is generated and held overseas (due to the high repatriation tax rate of 35%), unless Congress makes good on the promise of a repatriation holiday, Microsoft will soon have to stop taking on so much debt or potentially risk losing one of the only AAA credit ratings in Corporate America.

 

 

Microsoft’s $85 billion in total debt is going to result in a lot of interest costs. Over the past decade Microsoft has benefitted from the lowest interest rates in history, which has allowed it to sell those bonds at a weighted average interest rate of just 1.9%.

 

However, if interest rates meaningfully rise over the coming years, Microsoft will eventually have to either pay off the debt as it comes due or refinance it at much higher interest rates that could more than double the firm’s annual interest expenses.

 

Overall, Microsoft’s greatest risks are the unpredictable nature of technology markets. While a business like Azure might look great today, competitive dynamics are almost certain to evolve over the next decade, which could commoditize any of the company’s growth drivers with little warning.

 

Fortunately, Microsoft has the diversification and financial strength to weather many of these storms without jeopardizing the safety of its dividend.

 

Microsoft’s Dividend Safety

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.

 

Microsoft’s Dividend Safety Score of 98 suggests that the company’s dividend is one of the safest and most dependable payments on Wall Street.

 

The company’s strong Dividend Safety Score is primary due to three major factors.

 

The first is a disciplined approach by management to maintaining a low and safe payout ratio.

 

As you can see, while Microsoft’s EPS and FCF per share payout ratios have been steadily climbing over time (a result of the dividend growing faster than EPS and FCF per share), the ratio has always been low enough to ensure the dividend is never threatened by an economic or financial downturn.

 

In fact, during the financial crisis Microsoft actually increased its dividend by an impressive 27%, and the company’s sales only dipped by 3% in 2009.

 

 

Microsoft’s dividend is also nicely secured by company’s predictable free cash flow generation. You can see that Microsoft has generated positive free cash flow each year for more than a decade, and continued growth of the company’s recurring revenue businesses will further solidify this cash flow, which pays the dividend.

 

 

The final protective factor is Microsoft’s bulletproof balance sheet, which continues to be one of the best of any corporation in the world.

 

While Microsoft does carry $85 billion in debt, its $122.8 billion pile of cash is the second largest hoard of money on earth (behind Apple’s $246 billion).

 

Comparing Microsoft’s balance sheet to its peers, we can see that the company’s average leverage ratio, below average debt/capital ratio, and high interest coverage ratio explain why Microsoft’s credit rating is AAA.

 

Microsoft’s credit rating is higher than that of the U.S. treasury and is shared by only one other company in America (Johnson & Johnson).

 

Company	Debt / EBITDA	EBITDA / Interest	Debt / Capital	S&P Credit Rating
Microsoft	2.90	18.3	38%	AAA
Industry Average	2.93	NA	47%	NA

Source: Morningstar, Fast Graphs

 

Simply put, Microsoft’s dividend is one of the safest in the world.

 

Microsoft’s Dividend Growth

Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

Microsoft’s Dividend Growth Score is 70 indicates that shareholders are likely to enjoy stronger than average income growth from Microsoft in the coming years.

 

That’s not a surprise given the impressive double-digit growth rate of the company’s payout over the past 14 years.

 

 

Assuming Microsoft maintains a moderate FCF payout ratio of 50% (large enough to allow for R&D and acquisitions, as well as steady buybacks) and grows its earnings around 10% annually in the years ahead like analysts expect, the company should have no trouble continuing to grow its dividend at a high single-digit or low double-digit annual rate.

 

Valuation

Microsoft’s stock has returned 22% over the last year, topping the S&P 500’s gains and causing many investors to wonder if shares are now overvalued, especially since the entire market is trading at a high valuation relative to history.

 

MSFT currently trades at a forward P/E ratio of 22.2 and offers a dividend yield of 2.4%, which is just below the stock’s five-year average dividend yield of 2.6%.

 

The stock’s relatively high P/E multiple reflects analysts’ expectations for Microsoft to deliver at least 10% annual earnings growth in each of the next several years.

 

If the company can make good on its growth promises, now that the Nadella-led turnaround is well underway, then Microsoft rightfully deserves a higher valuation than it did in the past and will rather quickly “grow into” its high P/E.

 

However, my general preference is to pay no more than 15-20x earnings when I initiate a position, and I have to feel really good about a company’s moat and long-term growth opportunities to buy at the higher end of that range.

 

MSFT’s P/E is above my personal comfort level, and I’m not completely sold on the company’s ability to deliver double-digit earnings growth over the long term given the dynamic nature of tech.

 

A stock price in the mid to upper $50s (MSFT currently trades at $66) would make me more interested.

 

Concluding Thoughts On Microsoft

It’s still far from certain that Microsoft’s turnaround story will prove as successful as many investors hope.

 

The tech landscape is constantly evolving, and Microsoft is battling for market share with other giants that have very deep pockets.

 

Regardless, Microsoft’s dividend is extremely safe and has excellent growth prospects over the next few years thanks to its healthy balance sheet, consistent free cash flow generation, and the company’s continued transition to a more recurring revenue-based, cloud-centric business model.

 

These factors suggest Microsoft is a reasonable long-term holding for a diversified dividend growth portfolio.

 

However, I would prefer to see a more attractive entry point that better compensates me for some of the competitive risks Microsoft faces in its growth markets.

 

For now, I will continue to watch Microsoft along with some of the other best dividend stocks for income.