This is a Guest Post by Derek of EngineermyFreedom.com
Microsoft (MSFT) was founded in 1975 by a young Bill Gates and Paul Allen in New Mexico. Most people will recognize the Windows operating system but Microsoft develops a wide range of software services and devices. This includes server applications; business solution applications; desktop and server management tools; software development tools; and video games.
As a tech company it has seen some impressive growth in terms of price appreciation over the last decade, growing from $31 in 2010 to ~$224 at the time of writing. This is an impressive turnaround from their “lost decade” in the first 10 years of the millennium.
However, I am a dividend growth investor. And, on this front, Microsoft has increased their dividend for the last 18 years. This makes them a dividend challenger and close to becoming a Dividend Champion.
Today I will be analyzing MSFT from a dividend growth perspective.
Microsoft Operating Segments
MSFT operates three segments: Productivity and Business Processes, Intelligent Cloud, and More Personal Computing. In terms of revenue, all 3 segments were relatively equal in 2020 with close to 33% each.
Productivity and Business Processes
This segment consists of products and services in a portfolio of productivity, communication, and information services, spanning a variety of devices and platforms. This segment primarily comprises:
Office Commercial is designed to increase personal, team, and organizational productivity through a range of products and services such as Office 365. Office Consumer is designed to increase personal productivity through a range of products and services such as Microsoft 365, Skype, Outlook.com, and OneDrive. LinkedIn is a social media platform for professionals. Dynamics provides cloud-based business solutions for financial management, customer relationship management (“CRM”), supply chain management, and other application development platforms for organizations.Intelligent Cloud
The Intelligent Cloud segment consists of public, private, and hybrid server products and cloud services. This segment primarily comprises:
Server products and cloud services including Azure, SQL Server, Windows Server, Visual Studio and GitHub. Enterprise Services includes Support Services and Microsoft Consulting Services.More Personal Computing
Microsoft’s More Personal Computing segment consists of products and services that put customers at the center of the experience with their technology. This segment primarily comprises the Windows operating system, including Windows OEM licensing.
Microsoft Company Growth
Income Statement
When analyzing a company’s financial position, I start with the income statement. I generally look through 10 years of statements where I am interested in the average growth of revenue, net income, and earnings per share. I am looking to see if there is a demand for a company’s products, if they generate profit after costs and taxes and their earnings are growing.
Microsoft has a market cap of $1.6 trillion and has a book per share value of around $16.30. Since 2016, revenue has grown from $91.154 billion to $143.015 billion in the 2020 Annual report. That is a compound annual growth rate of a little over 11.92%.
During the same period Earnings Per share grew from $2.56 to $5.56. There was a slight dip in 2018 due a $13.7 billion net charge related to the enactment of the TCJA. Growth has been helped by Microsoft’s share repurchase program. They completed $40 Billion in share repurchases between 2016 and 2020.
On September 18, 2019, the Board of Directors approved a share repurchase program authorizing up to $40.0 billion in share repurchases. This share repurchase program commenced in February 2020. As of June 30, 2020, $31.7 billion remained of this $40.0 billion share repurchase program.
In 2020 the Operating margin was 37% which is higher than the 10-year average of 33.8%. The Gross margin was 67.8% which is on par with the 10-year average of 68%.
Balance Sheet
Microsoft has total assets of $301 Billion and liabilities of $183 Billion, This gives a healthy $118 Billion in Shareholder equity. Some of the assets may be listed as “goodwill”. If goodwill and other intangible assets are excluded from total assets when calculating shareholder equity, you get tangible book value per share of $8.97.
When a company acquires another company and pays a price that is higher than the tangible book value of that company, they’ll incur a loss on their balance sheet and income statement. To avoid this problem, the acquiring company can put the difference between the purchase price and tangible book value of the acquired company on their balance sheet as “goodwill”. Whenever you see an increased amount of goodwill over several years you can assume the company has been buying other businesses. Depending on the business they bought, this can be a good thing.
Over the years, Microsoft has made many acquisitions, and average Goodwill/Equity over the last 10 years of 29%. This jumped significantly in 2017 to 37% due to the acquisition of LinkedIn but this is still an acceptable level for me.
Cash, cash equivalents, and short-term investments totaled $136.5 billion and $133.8 billion as of June 30, 2020. This is about 45% of their balance sheet. The total debt/equity is 44% which means they have $0.44 of debt for every $1 of equity. Interest coverage is quite high at over 20 so they can more than cover the interest on their debts. Total debt/ EBITDA stands at 1.22.
Overall, Microsoft has one of the best balance sheets in the game and deserve their AAA credit rating.
Microsoft Dividend Quality
Microsoft is not often talked about as a dividend stock, as its starting yield is usually low. At the time of writing, it is hovering around 1%. It is hard to get excited about a 1% yield when you have companies such as these 3 compelling high dividend stocks.
Part of my investment thesis is to invest in companies that show a history of increasing dividends but also show good potential to continue to raise them. Companies that generate sustainable earnings growth often make the best dividend companies, as it is easier to lift the dividend when earnings are rising.
Free cash flow has grown considerably, from 24 billion in 2009 to 45 billion in 2019, which is an average growth of 8.4% per year.
Not only do Microsoft tick all these boxes from a growth viewpoint. They also have increased their dividend for the last 18 years in a row. Since 2004 the average dividend increase was 15.15%. The dividend growth rate over the last 5 years is 10.45% compared to 6.23% for the S&P 500.
The payout ratio is a good indicator of the sustainability of dividends. As a European dividend investor I am used to a conservative rate of below 50%. However, for US companies I tend to like anything under 70%. Microsoft typically pays out between 30% and 40% of free cash flow on dividends, with the 10-year average being 33%.
It might be no surprise that Microsoft has one of the safest dividends in the whole market. A rapidly growing business with a strong balance gives me the confidence in estimating double-digit dividend growth over the next decade.
Conclusion
Microsoft is one of the strongest companies in the world. They have plenty of catalysts for growth over the next decade. Microsoft has shown excellent dividend growth, and has one of the strongest balance sheets you can find.
The question is, should I buy Microsoft? With a dividend yield of 1% and a P/E ratio of 30, MSFT stock is certainly not cheap. But quality is very rarely cheap. From my Dividend Discount Model and Discounted Cash Flow Model, I value MSFT at around $180.
Personally, they are a little too overvalued for me but I will consider MSFT stock again if it returns to the $200 mark.