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Microsoft: A Dividend Growth Giant

publication date: Jan 9, 2018
author/source: Brian Nelson, CFA

Microsoft is no longer a tech dinosaur. Estimates suggest it is beating Amazon at its own game. We’re huge fans of Microsoft’s free cash flow generation and balance-sheet health and what that means for the dividend. There’s not a lot to dislike about Microsoft, and while the risks are many, few company’s have a stronger business model.

By Brian Nelson, CFA

Many of you know Microsoft (MSFT) well. The company’s products run the gamut in technology and include operating systems, cloud services, server applications, desktop and server management tools, software development tools, video games, and online advertising, among other things. It also designs, manufactures and sells hardware, including PCs, tablets, gaming consoles, and other smart accessories that integrate with its cloud offerings. What I find to be one of the more compelling things about Microsoft, however, is not so much what it is today, but what it might be in the years ahead, as technology continues its breakneck pace of innovation.

I think many investors thought Microsoft was a tech dinosaur, perhaps as recently as a few years ago, but momentum behind new devices and platforms, Windows 10, Office 365 and Azure continues to build. The company’s cloud-based product suite, Office 365 and Azure, continues to gain popularity among both consumers and enterprises at impressive rates. This momentum helped Microsoft achieve its goal of $20 billion in commercial cloud annual recurring revenue well ahead of schedule. According to estimates, Microsoft’s cloud revenue is even greater than that of Amazon (AMZN) Web Services, meaning that if you like Amazon, you probably must love Microsoft, right? Cloud-based revenue at Microsoft is even growing at a faster clip than Amazon’s. I find these statistics incredible given the buzz around Amazon these days.

As you may already be aware, Microsoft recently acquired LinkedIn for over $26 billion in cash, and we weren’t exactly thrilled with the transaction as Microsoft may have overpaid a bit, but we’re not too worried about it. The deal is expected to be dilutive to earnings per share in coming years, but Microsoft’s impressive financial profile continues to give us confidence in the enterprise moving forward, and its tremendous free cash flow generating capacity has not wavered. Microsoft’s net cash from operating activities has advanced to $39.5 billion in fiscal 2017 from $29.7 billion in fiscal 2015, implying tremendous growth for this behemoth (where it counts), while additions to property plant and equipment have been relatively contained under $9 billion during the past two years. In fiscal 2017, Microsoft generated traditional free cash flow of $31.4 billion, a measure that is a multiple of the cash dividends it paid during the year, $11.8 billion, implying tremendous dividend coverage with traditional free cash flow alone.

What’s more, Microsoft can't scoop up its own shares fast enough through its massive buyback program. In the fiscal first-quarter of 2018 (the calendar third quarter of 2017), Microsoft returned $4.8 billion to stockholders in the form of share repurchases and dividends, just an incredible sum of money for a company even of any size. The software and cloud giant floats debt with the best credit quality, too, and we can't think of another company with a better financial profile, save for maybe Apple (AAPL). Financial discipline and strong execution remain hallmarks of Microsoft’s business. At the end of fiscal 2017, Microsoft ended the year with total cash and short-term investments of $133 billion and total short and long-term debt of ~$86 billion, revealing a nice net cash position that covers annual dividends a multiple of times, too!

I think you’re getting the gist of this article. Even if we look at Microsoft’s free cash flow generation alone, the company has room to keep raising the dividend payout, but it has incremental cushion on the balance sheet, even after netting out its debt position. Microsoft’s financial statements reveal that it has tremendous dividend growth potential, and we would not be surprised to see an acceleration in the pace of dividend expansion above the near-8% hike in the payout last September. To a large extent, it comes down to how the executive team feels about the tradeoff between dividend growth and buybacks because with Microsoft’s free cash flow generation and balance-sheet health, there’s just a lot of cash in the business that may eventually find its way into shareholder hands one way or another.

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But investors should still keep their heads about them. Our valuation of Microsoft is not too aggressive, but we think it is optimistic, and we’re arriving at a discounted cash-flow fair value estimate of ~$79. We’re modeling in 7% compound annual growth during the next 5 years on solid average operating margins, resulting in a rather strong pace of earnings expansion. We’re using a weighted average cost of capital assumption of 9%+, so we could be a bit high in the discount rate, but even considering sensitivity analysis, we’d put the high end of Microsoft’s fair value estimate at ~$95 at the moment. Shares aren’t necessarily cheap, but as the company continues to haul in more and more cash, its value has all the potential to grow into its price. If the team hikes the dividend in a big way, then the marketplace may simply go bananas over Microsoft! Some are even saying that Microsoft could fetch a market capitalization of $1 trillion in coming years.

Let’s cover a couple risks. The first, of course, is that technology is fast-changing, and while this spells opportunities, it also spells threats. Not everything that Microsoft dreams up will work out, but we think it is in the right spot long-term with cloud-based revenue. Rivals in that area will only get stronger, but given recent trends, Microsoft looks to be the one to beat. After the LinkedIn deal, we're a little cautious management may jeopardize the health of its balance sheet with another reckless acquisition during the frothiest times the market has yet seen, but we hope not. We’re using evidence of the net cash buffer as an indication of management’s prudence. Once net cash turns to net debt on the balance sheet, if it ever does, then we’d start to worry about the pace of growth in the dividend. There’s not a lot that would make us worry about the health of the actual dividend at this point, however, only the rate of expansion. Some are saying that Microsoft could make a huge security acquisition, but we’re not much for speculation, even if a deal does end up coming to fruition.

All things considered, here’s what you need to know about Microsoft: it is no longer a tech dinosaur--if it ever was one--its cloud business is growing like a weed, it generates tremendous free cash flow that covers the dividend nicely, its balance-sheet health is top-notch, it has solid revenue prospects--especially for a company of its size--and its dividend growth prospects are fantastic, in my view. We’re hoping Microsoft steps up the pace of dividend growth in coming years, and maybe scales share repurchases back a bit, but we’re big fans of the executive team and respect their judgment. Shares of Microsoft yield ~2% at the time of this writing. We continue to like this software and cloud giant!


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