Microsoft: Catalysts For Dividend Increases And New Highs

Dec. 5.13 | About: Microsoft Corporation (MSFT)

Microsoft (NASDAQ:MSFT) shares have been on a tear over the past year, posting gains of roughly 50%, rising from $26 to near $39 at present. The company is in the midst of several potentially game-changing events including a search for the new CEO, PC shipments falling and the new Xbox console, to name three. However, MSFT's results and share price have proven that the tech giant is on the right course but have the shares come too far too fast? In this article we'll take a look at MSFT's earnings and a recent debt issue in the context of pricing shares.

To start, below is my earnings model that uses various metrics in order to compute a fair value for shares. If you'd like to read more in depth about the model, please see here.

2013

2014

2015

2016

2017

2018

2019

Earnings Forecast

Prior Year earnings per share

$2.65

$2.66

$2.91

$3.12

$3.34

$3.58

x(1+Forecasted earnings growth)

0.40%

9.40%

7.18%

7.18%

7.18%

7.18%

=Forecasted earnings per share

$2.66

$2.91

$3.12

$3.34

$3.58

$3.84

Equity Book Value Forecasts

Equity book value at beginning of year

$9.78

$11.32

$13.06

$14.94

$16.99

$19.21

Earnings per share

$2.66

$2.91

$3.12

$3.34

$3.58

$3.84

-Dividends per share

$1.12

$1.18

$1.23

$1.30

$1.36

$1.43

=Equity book value at EOY

$9.78

$11.32

$13.06

$14.94

$16.99

$19.21

$21.62

Abnormal earnings

Equity book value at begin of year

$9.78

$11.32

$13.06

$14.94

$16.99

$19.21

x Equity cost of capital

8.50%

8.50%

8.50%

8.50%

8.50%

8.50%

8.50%

=Normal earnings

$0.83

$0.96

$1.11

$1.27

$1.44

$1.63

Forecasted EPS

$2.66

$2.91

$3.12

$3.34

$3.58

$3.84

-Normal earnings

$0.83

$0.96

$1.11

$1.27

$1.44

$1.63

=Abnormal earnings

$1.83

$1.95

$2.01

$2.07

$2.14

$2.21

Valuation

Future abnormal earnings

$1.83

$1.95

$2.01

$2.07

$2.14

$2.21

x discount factor(0.085)

0.922

0.849

0.783

0.722

0.665

0.613

=Abnormal earnings disc to present

$1.69

$1.66

$1.57

$1.50

$1.42

$1.35

Abnormal earnings in year +6

$2.21

Assumed long-term growth rate

3.00%

Value of terminal year

$40.15

Estimated share price

Sum of discounted AE over horizon

$7.83

+PV of terminal year AE

$24.61

=PV of all AE

$32.44

+Current equity book value

$9.78

=Estimated current share price

$42.22

Click to enlarge

If we take a look at the results of the model, given the earnings estimates used, my model computes a current fair value for MSFT shares of over $42, or a roughly 8% premium to today's price. What does this mean? The model computes a fair value for shares today with the information provided; it isn't a static price target. Rather, it is what one could pay for MSFT shares today and not pay a premium to their theoretical intrinsic value. Thus, according to my model, MSFT shares are pretty cheap.

Why are shares still cheap even after the huge run they've enjoyed? It's likely a confluence of factors rather than one event. For instance, the company has clearly produced a winner in the Xbox One console. While the consoles are reportedly sold at a loss, MSFT is opening the door for software and services sales for years and years to come. The more gamers that get involved in MSFT's ecosystem, the more non-hardware sales MSFT will eventually realize. In addition, the CEO search has been a source of optimism among investors. There are two very strong candidates at present, Alan Mulally and Satya Nadella. Nadella is a Microsoft vet with very strong credentials and we all know Mulally from Boeing and Ford. Either one is likely a worthy replacement for the outgoing Ballmer. Finally, the dividend yield of nearly 3% is likely attracting investors and keeping shares somewhat buoyed as yield can be difficult to find in the current environment.

Microsoft, apart from all of those positives, has another catalyst for shares to keep the impressive rally moving; buybacks. Earlier this week MSFT sold $8 billion worth of bonds of various maturities in euros and dollars. The interest rates paid were, of course, miniscule and it allows MSFT to borrow against its foreign cash for almost nothing. While MSFT was mum on the use of the money you can bet it is going towards buybacks; with $80+ billion in cash on the balance sheet it isn't like MSFT needs the money to keep the lights on. However, borrowing against foreign cash allows MSFT to retire common shares while also enjoying the tax benefits of paying interest expense. Thus, the math works out to save MSFT money on its dividend payments and also accrues benefits to shareholders via a lower outstanding count. With MSFT's 19% tax rate (fiscal 2013), it will enjoy roughly that amount of income tax savings on the interest it pays on these bonds. As a result, the after-tax cost of the bonds is actually 19% lower than the coupon rate. Then consider that MSFT common shares pay 2.9% dividends and you'll see the math works out for MSFT; if it simply borrows money at an after-tax rate lower than 2.9% (which most of the new issues are) and then repurchases common shares, shareholders win both ways. MSFT saves money on its dividend payments and shareholders enjoy commensurately higher EPS due to a lower share count. This will also allow MSFT to eventually pay a higher dividend per share as there will be less shares outstanding. In other words, I love this move.

Microsoft shares have undoubtedly enjoyed a very impressive run over the past year. With shares at multi-year highs, they are still quite cheap. My model computes a current fair value of about $42 and with shares trading at just 13 times next year's earnings, they certainly look cheap. In addition there are several catalysts for moving the shares higher into next year as well. The Xbox One is selling very well, the CEO search seems to be going as planned and a new debt issue looks to save the company money and lower the share count simultaneously. With a yield near 3% and a rock solid balance sheet, what's not to like?

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in MSFT over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.