Microsoft (MSFT) has a dominant franchise in both office and Windows as well as strong free cash flow growth. Yet current trends leave me less certain about Microsoft's medium-term dividend growth prospects.
Microsoft is a giant of the technology industry. The owner of the dominant Microsoft Windows and Microsoft Office franchises, Microsoft is a $225B company with more than $70B in annual revenue and 76% gross margins with net income of close to $17B.
The Microsoft Business Division (which is really the Microsoft Office franchise) actually accounts for most of Microsoft's revenue (close to 35%). The Server and Tools Business and Microsoft Windows Business are fairly close in terms of revenue contribution at almost 25% each. The entertainment division (think XBOX) and online services division make up close to 15% revenue between them.
The Windows and Office franchises have been dominant for lengthy periods of time. Office has greater than 90% of market share in the enterprise productivity market, and frankly it the the anchor point for much of Microsoft's other revenue streams.
Why is this the case? Much like with the mobile device ecosystem, a operating system (whether it be Android or Apple's iOS ) is only really as useful to someone as the things that you can do with that operating system. In the case of Microsoft Windows, the things that someone can do with Windows come down to the productivity tools that are available to you with Microsoft Office (word processing, spreadsheeting etc).
So Microsoft Office really drives much of the Windows Business, as well as the Microsoft Server business in my view (there won't be much of a need for an enterprise to have Windows Servers if there aren't many machines running Microsoft Windows solutions, or Microsoft Office). So for the Microsoft growth case to remain strong, you have to believe that Microsoft Office will continue to remain a dominant franchise.
Where is the Growth?
PC sales flat - Microsoft Office is predominately deployed on PCs and laptops. What is the forecast for PCs? Barclays have estimated PC growth declines of some 2% over 2012 and some 4% in 2013. There are not many compelling reasons to upgrade PCs, and with tablets increasingly becoming computing devices of choice, it's unlikely that there is a catalyst to reverse this decline in the next few years.
Smartphone and Tablet - Smartphone and Tablets are the computing devices that are experiencing rapid growth, at the expense of the PC market. How does Microsoft figure in the rankings? According to Commscore, Microsoft had only a 3.6% share of mobile devices as of September 2012. Microsoft also launched its own tablet offering, the Surface tablet. While it's still early days for the Surface, analyst commentary suggests sales have thus far been fairly weak.
Microsoft Office Pricing - Pricing is one way that Microsoft could expect to shore up Office revenues. How is Office pricing expected to hold up? Microsoft had a 20% price cut on their Office 365 product in early 2012. Trefis estimates that pricing for Microsoft Office Enterprise licenses will fall from $49 to almost $40 a license by 2018. That would be a major headwind for Microsoft if that were to materialize.
BYOD (Bring your own device) - There is an increasing trend of users to bring their own devices into the workplace and have IT make them work. The iPad kicked off this trend, and it's only been accelerating since. Its unclear how these trends may impact Microsoft revenue, but I believe Microsoft charge based on a Client Access License (a Per User License). So if an individual is bringing in an additional device and hooking up an enterprise instance of Microsoft Office, it isn't clear to me that Microsoft is making additional revenue, as it's still the same user.
Google Apps and Quick Office - The last few years have seen an emergence of competitors to Microsoft Office including Google Apps and Quick Office (Google recently bought Quick Office to strengthen the Google Apps franchise). While these products are mainly gaining share in the SMB and smaller enterprise market they will likely serve to keep a cap on Microsoft Office pricing even if they don't lead to a loss of Microsoft share (though I expect Microsoft will see some small share declines over time).
As a dividend growth investor, I want to be able to see some signs of operating income growth, cash flow growth and therefore dividend growth for years to come.
What do the numbers say?
(I used morningstar.com for this analysis)
10yr /5yr revenue
Microsoft compound revenue growth over the 10 year period (2003-2012) has been a very acceptable 10% p.a.
Both "halves" have been roughly equal 2003-2007 revenue growth was a good 12% p.a while 2007 to 2012 has been a more modest 8% pa, slower but still reasonable for a company its size.
10 yr / 5 year operating cash flow growth.
Microsoft operating cas hflow over the year period has also been a modest 8% p,a. 2003-2007 yearly cash flow growth was a meager 3% p.a for the period, while 2007-2012 has been 12% p.a., more what you would expect given the revenue growth and high gross margins its been generating.
Dividend Growth Rates
During the 2003-2012 period, Microsoft has had an impressive dividend growth rate which has averaged an impressive 28% p.a. And in the last 5 years? Microsoft's dividend from 2007 to 2012 has increased 14% p.a over this period, roughly in line with operating cash flow growth.
A review of the payout ratio in recent years suggest a slight uptick, though at around 40% this is not of any great concern.
Microsoft is a solid business, built on the back of dominant positions in Windows and Office. Revenue growth is still very respectable, at close to 10% p.a over an extended period of time, with good operating cash flow generation. Dividends have also been increased strongly in recent times, consistent with operating cash flow generation. The numbers and historical performance at Microsoft go quite a distance to putting to rest any suggestions that it can't continue to grow revenues, dividends and cash flow strongly.
While I expect dividend growth to continue at Microsoft into the medium term, some of the emerging trends of declining PC sales and BYOD combined with Microsoft's inability to make significant inroads into mobile lead me to expect that it may not be able to increase its dividend as significantly as it has done in recent times.