Citigroup's equity strategists recently added Microsoft (MSFT) to their list of top dividend stocks. Their methodology, based on CDS levels, is clearly very different than mine. I approach dividend stocks from a Warren Buffett perspective and want to find companies that can be owned for decades and will increase their dividends over time. Microsoft now seems to be at its most vulnerable point in years and carries too much business risk for a long-term dividend holding. Furthermore, it does not even seem attractive on a short-term time frame either. In this article I will analyze Microsoft from these two perspectives and explain why it doesn't make the cut for my dividend list.
Citigroup's Dividend List
According to Barron's, Citigroup used the following criteria for its dividend selection:
Citi looks for stocks with a market cap north of $10 billion that combine high dividend yields with solid financial health as gauged by the market for credit-default swaps. Previously, the list required dividends to be at least 1.5 percentage points higher than median-yielding stocks, but this month Citi dropped that to 1.0 percentage points. The list is then filtered for companies with CDS spreads in the lowest third of Citi's coverage universe (the lower the CDS, the lower the perceived credit risk). Beyond that, Citi now seeks positive dividend momentum per consensus forecasts.
Citigroup's timeframe is unclear from the Barron's article, but I don't consider "CDS spreads in the lowest third of Citi's coverage universe" a sufficient indicator for the long-term investor.
Background: Stock Price
Microsoft has been trading in the $22-$32 per share range for most of the time since the tech bubble burst.
However, on a shorter time frame, it looks like Microsoft may be in a downtrend going back to Q1 2012 and the stock faces a big test in the ~$29.70-$30.00 range.
With a 3.23% dividend yield Microsoft understandably gets attention as a dividend candidate. Furthermore, Microsoft has been increasing its dividend since 2003.
MSFT Dividend Yield data by YCharts
Summary Of Microsoft's Business
Microsoft has five main divisions, but two generate the majority of the company's profits: Windows Division and Microsoft Business Division (MBD) (which is primarily Microsoft Office and related products).
The server business also generates operating profit, but the entertainment business is only breakeven and the online business is slightly unprofitable.
Because Windows and MBD are the cash cows of the company I will focus on these divisions.
I have three main short-term concerns about Microsoft: 1) weak PC sales forecasts, 2) Windows 8 and new products and 3) declining earnings estimates.
Weak PC Market Forecasts
Microsoft's main divisions are facing a challenging market environment.
On March 18, 2013, research firm IDC said the following about global PC sales in 2013:
"Based on our latest quarterly figures, global PC shipments were expected to decline by 7.7% in the first quarter as vendors and the supply chain work through the Windows 8 transition," said Loren Loverde, Program Vice President, Worldwide PC Trackers at IDC. "However, our February monthly data suggest that we could see a drop touching double-digits in the first quarter and a mid-single-digit decline in the second quarter before we see any recovery in the second half of the year. Even getting to positive growth in the second half of 2013 will take some attractive new PC designs and more competitive pricing relative to tablets and other products." (Source: IDC)
There are many reasons for PC weakness, including slower global growth, weak IT spending as well as the increasing popularity of tablets.
Microsoft's sales may outpace PC sales because it is ending support for Windows XP in April 2014, which forces users to upgrade. On the last earnings call (here) Microsoft's management said that 60% of enterprise desktop users have migrated to Windows 7 and 90% expressed interest.
There are still many more Windows XP users that will need to migrate allowing Microsoft's Windows sales to exceed PC sales as XP users that upgrade will not necessarily need new hardware.
Nonetheless, the PC market is weak and it is not a good sign that estimates are going down.
Windows 8 And New Products
I was pleasantly surprised by Windows 8 and some of Microsoft's new products. Microsoft has a lot riding on the new product cycle and it delivered a fresh new set of products that look good. However, the market reception has been lukewarm, at best.
There was an interesting Q&A about this on the last earnings call:
Kash Rangan - Bank of America Merrill Lynch
...It's already quite a bit into the year, but what I was wondering was in the holiday season post a launch for Microsoft typically we get a big effect to the PC industry. It's happened every cycle, and I guess we had some competition from tablets and we didn't quite see that kind of whiz-bang effect with a typical Windows launch.
I am curious to get your take on what is it that the media and the industry seems to have gotten it wrong? What are the misperceptions about Windows 8, and how do you think the year is going to play out as far as Windows 8 receptivity in the consumer market and business market.
Peter Klein - Chief Financial Officer
Yes. Thanks, Kash. Windows, as I talked about, Windows 8 is a sort of big, bold, re-imagining of Windows across the whole ecosystem, and I think this was the start of that process. I think, we all collectively learned a lot about from the user interface to the touch devices. And, as I tried to give context on the call, there's a lot of things we are working on with our partners that I think to continue to drive this process forward over the next several quarters whether it's the chipset, whether it's with developers or the kinds of applications that people want and certainly for the kinds of touch devices that they write, price points that consumers want I think all of that continuously improving, we are continuously learning and happens over time, but this is a big ambitious re-imagining of Windows, and this quarter was the first step in that process.
As Microsoft's CFO said, Windows 8 is a "big ambitious re-imagining of Windows." Generally, when a new, bold product has a successful launch there is clear demand and excitement. Microsoft's management comments about "learning" from the launch seems to indicate the opposite.
To Microsoft's credit, management seems to be iterating faster than in the past and may be able to tweak the products to get more demand.
On a more positive note, it seems that Windows Phone is gaining market share, according to TechCrunch, but it still represents a very small portion of the market and I don't expect Windows Phone to be a meaningful competitor to Apple's (AAPL) iOS or Google's (GOOG) Android over time. For interesting commentary about the Windows Phone 8 app ecosystem, please see a recent Wired article here.
Similarly, it doesn't seem that the Surface tablet is gaining much traction.
Declining Earnings Estimates
It is hard to know how the new products are selling until earnings come out. Wall Street analysts should have better visibility and changes in their earnings estimates reflect their optimism/pessimism.
Over the last few months, analysts' earnings expectations have come down slightly.
FQ1 is the quarter ended in March and FY1 is the fiscal year ended in June 2013.
(Source: Yahoo Finance)
Microsoft may have a great future ahead of it, but why should a dividend investor buy the stock when the company is at its weakest competitive position in years and the first attempt to fight back is falling short.
Over the long term, I have three main concerns that prevent me from considering Microsoft as a dividend holding: 1) competition, 2) pressure on margins, 3) difficult industry.
It has been a long time since Microsoft had real competition in its core markets: the operating system and business apps.
Microsoft is far behind Apple and Google in terms of mobile operating systems market share. However, it still maintains the lead in terms of desktop operating systems.
(Source: Net Applications, via Wikipedia)
Many enterprise customers rely on PCs and will likely continue to do so for their high-end needs. However, tablets could begin to replace PCs for low-end computing functions and certainly have an advantage over PCs for mobile workers.
Furthermore, with all the money that Microsoft is making from desktop operating systems there is a big incentive for Google to continue to improve its operating systems and try and take market share from Microsoft.
In terms of business applications, Google is already challenging Microsoft at the low end of the market. Again, Microsoft has an advantage in the high end but many business customers don't need to overpay for functionality that they might not need.
It is too early to know how these competitive dynamics will play out. Microsoft may indeed maintain its leadership position. However, from the perspective of a long-term dividend investor it seems that Microsoft is now more vulnerable to competition.
Even if Microsoft continues to dominate the market for desktop operating systems and business applications, it may need to cut prices.
The business applications side may experience this pressure first.
The following is the pricing for Google Apps (see here):
- Google Apps For Business: $5/user/month or $50/user/year
- Google Apps for Business with Vault: $10/user/month
And, for Microsoft Office (see here):
- Office 365 Small Business Premium: $12.50 user/month annual payment of $150.00 or $15.00 user/billed monthly
- Office 365 Midsize Business: $15.00 user/month annual commitment
- Office 365 Enterprise E3: $20.00 user/month annual commitment
There are additional pricing options for Microsoft, see here.
Microsoft's products probably offer better functionality, but the competition from Google will likely pressure Microsoft's prices, especially as Google's products get better.
Microsoft recently started offering Office 365 to students for free for six months (see pcmag.com). I wonder if this is indicative of more price cuts to come.
It is difficult to find good long-term dividend stocks in the technology space.
I actively invest in tech stocks when I am short-term oriented, but few tech companies are on my long-term dividend list.
The main problem with tech stocks is the rapid pace of change. All companies must evolve over time, but the industry cycles are much shorter in the tech space. Furthermore, many areas of the tech space suffer from price deflation. From a long-term perspective, I rather invest in industries that can benefit from the natural inflation in the economy.
I have some investments that are short-term oriented and some that are for the long term. For the long term, I prefer companies that can be owned for decades with potential for attractive dividend growth. Therefore, I was surprised to see that Citigroup put Microsoft on its dividend list. Citigroup's time frame may be different than mine, but Microsoft falls far short of what I look for in a dividend stock. The CDS spreads, which Citigroup uses, are not helpful in evaluating a company's long-term potential. Microsoft is at a vulnerable position on a short- and long-term time frame, so I am keeping it off my dividend list.
Additional disclosure: I may trade any of the securities mentioned in this article at any time, including in the next 72 hours.
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