As a private investor, I generally look for dividend income stocks with stable growth in both revenue and earnings per share. Finding attractive stocks for my portfolio is not as easy as it was a year ago because the stock market rallied in 2013. As a result, many dividend income stocks seem somewhat expensive right now. In my opinion, Microsoft (MSFT) is not one of those overpriced stocks.
Microsoft has a very strong financial position. This supports the quarterly dividend payments, repurchases of its own shares and enables the company to make investments. Therefore, I added Microsoft shares to my portfolio last Friday. This article provides four arguments why I added Microsoft to my portfolio. I will discuss several threats and downside risks as well.
1. Cloud services
Microsoft's strongest growth driver is commercial cloud services. Cloud services revenue grew $261 million, or 103%, during the first quarter of this fiscal year compared to last year's first quarter. Microsoft invests in data centers to support the strong growth in commercial cloud services. For example, it is likely that the company invests $2 billion in a new data center in Europe this year (see this article).
Amazon (AMZN) remains the dominant player in the commercial cloud services business, but Microsoft is closing the gap quickly. One of Microsoft's key competitive advantages over Amazon is that Microsoft's cloud services offer a better support for other popular commercial applications and software (see this article). Therefore, Microsoft should be able to grow cloud services revenue in the upcoming years.
Bill Hilf, general manager of product management for Microsoft's Azure, stated in this article: "Amazon is nowhere near ready for this battle in the enterprise." Due to a strong position in the corporate IT market, Microsoft is able to grow cloud services revenue at such a quick pace. This is also pointed out in this article. The author stated:
But it's worth noting that while much of the attention and hype around cloud services goes to startups like Box and Dropbox and to internet pioneers like Amazon and Google (GOOG), many of the actual dollars spent are quietly flowing to stodgy old Microsoft thanks to the company's dominance of the unsexy business of selling to corporate IT departments.
2. Mobile devices
Microsoft announced a $7.5 billion transaction to acquire Nokia's (NOK) mobile devices business on September 3, 2013. The deal enables Microsoft to take on Apple's (AAPL) and Google's (GOOG) dominant market positions in the smartphone market. Currently, Microsoft has only 4% market share in the smartphone market (see this article). Also, the deal will provide synergy benefits. Microsoft expects that these synergy benefits will be around $600 million per year.
The acquisition could turn out to be a very lucrative deal for Microsoft, especially when the company succeeds to grow its market share in the smartphone market. Microsoft stated that it would have to sell $50 million smartphones annually to break even. Nokia sold 8.8 million smartphones in the third quarter of 2013 (see graph below). Therefore, Microsoft needs to grow Lumia sales at least 40% in order to break even on smartphones.
Source: The Wall Street Journal
Growing Lumia sales at least 40% may look a lot. However, do not underestimate Microsoft's strong corporate connections and existing client base. The company has a lot of existing business customers who may be persuaded into buying Microsoft's phones. This could be a major catalyst for Microsoft to grow smartphone sales. Overall, I am confident that Microsoft will turn Nokia's smartphone business profitable.
Dividend income is an important factor in my investment decisions. Microsoft raised its dividend almost every year over the past 10 years (see graph below). On September 17, 2013, Microsoft announced that the company raised its quarterly dividend more than 20% to $0.28 a share, or $1.12 on an annual basis (see this link). Microsoft's current dividend yield is 3.03%, based on Friday's closing price.
I find this an attractive dividend yield considering the fact that the payout ratio is only 42% of Microsoft's net income. The pay-out ratio is relatively low compared to other large-cap dividend income stocks with a 3% dividend yield, for example: The Coca Cola Company (KO) (pay-out ratio: 58%), The Proctor & Gamble Company (PG) (pay-out ratio: 61%) and Cisco Systems (CSCO) (pay-out ratio: 37%).
Microsoft will be able to grow the dividend payments in the future given the company's financial position. The company has $80.7 billion in cash and short-term investments and only $26.1 billion in long-term liabilities on September 30, 2013, (see this report). The current annual free cash flow is $23 billion a year (see graph below). Therefore, I expect that Microsoft will be able to grow dividend payments in the future.
4. Share repurchase program
Another reasons why I added Microsoft shares to my portfolio is the company's share repurchase program. I generally like share repurchase programs because they lift earnings per share and support the share price. Microsoft completed a $40 billion share repurchase program on September 30, 2013. However, Microsoft announced that the board authorized another $40 billion share repurchase program for the next few years (see this article). The company's cash pile and free cash flow should be more than enough to cover for the share repurchase expenses without harming the day-to-day business.
Microsoft repurchased a lot of its own outstanding shares during the past ten years, decreasing the total number of shares outstanding from 10.8 billion in 2004 to 8.3 billion in 2014 (see graph below). The new authorized $40 billion share repurchase program will decrease the total number of outstanding shares even further. Microsoft will repurchase around 1 billion of its own outstanding shares, or 13% of the total shares outstanding, in the next couple of years.
Despite my bullish outlook, there are some factors to consider that could be a risk to Microsoft's business and its share price. First, the company is looking for a new CEO (see this article) to replace Steve Ballmer. The more time it takes to find a new CEO, the more investors get impatient. Impatience leads to uncertainty and uncertainty could hurt the price. Therefore, it is necessary that Microsoft takes away the uncertainty by appointing a suitable new CEO as soon as possible.
Another major threat is the increase in tablet sales around the world. Tablet sales increase where desktop PC sales decline (see this article). Microsoft has a strong position in the PC and laptop market. However, Microsoft has not (yet) developed a very strong position in the tablet market. The tablet market is dominated by Apple's iOS and Google's Android operating systems.
Finally, the acquisition of Nokia's mobile devices business may not be as profitable for Microsoft as I expect it to be. Microsoft needs to increase smartphone sales by 40% in order to break even on smartphones. Microsoft will lose money if the company does not increase smartphone sales by at least 40%. In that case, the $600 million synergy benefits will not cover for the annual operating loses.
This article provides four arguments why I recently added Microsoft shares to my portfolio. In my opinion, Microsoft's cloud services business will remain a major growth driver. Further, I am confident that Microsoft's management will turn the acquisition of Nokia's mobile devices business into a profitable transaction for the company. Finally, Microsoft pays a nice dividend and share repurchases will support earnings per share in the future.