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Executive summary:

  • Microsoft's dividend, share buyback program, valuation and growth prospects warrant investor interest.
  • However, there are an array of arguments against Microsoft's future prospects.
  • A technical evaluation of Microsoft at this time is mixed.

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When you read a Seeking Alpha article concerning stocks like AT&T (T), The Coca-Cola Company (KO) and other long time DGI favorites, you always have a half dozen readers who will regale you with tales of their investments. They usually begin their stories claiming to have made their investment around the time Nixon faced impeachment. They will then inform you that they have collectively paid for a Piper Cub, a beach front house in Florida, two cruises through the Mediterranean, three breast augmentations for their various wives and girlfriends and a South African safari… with dividend payments alone.

Yes, Dividend Growth Investors are arguably the most vociferous bunch in the investment community. I recently wrote an article concerning Ensco (ESV) in which I stated I considered ESV a nice addition to my Dividend Growth portfolio. The response made me imagine a group of DG investors gathering together with pitchforks and torches, like the village mob in an old FRANKENSTIEN movie. Ensco does not raise dividends on a regular basis (forget the 6% dividend), so ESV cannot be a Dividend GROWTH investment. Heresy!

Knowing my gang as I do, perhaps it should not surprise me when I see their relative lack of interest in Microsoft (MSFT) as a DG investment. DG investors seem to have distinctive favorites, and no other stocks will suffice.

I went to the excellent site of SA contributor David Fish. There on page 18 of his exhaustive list stands Microsoft, listed as a Dividend Contender. (Do not make my mistake and print out his list of DG stocks. I must now devote a fiscal quarter's worth of AT&T dividends to replenish my printer paper and ink)!

Microsoft began quarterly dividend payments in 2005, and with the single exception of 2010, the company increased their dividend on a yearly basis. Furthermore, the smallest quarterly dividend increase has been 10%. In 2012, 2013 and 2014, Microsoft upped their dividend 25%, 15% and approximately 17% respectively.

With back-to-back quarters exceeding analyst's expectations, you would think there would be greater interest in Microsoft as a DG investment.

So why wouldn't a DG investor purchase Microsoft stock as a cornerstone to his or her portfolio? I will say this: As I conducted research for my article, it seemed that whenever I found an argument in favor of the stock, I found a counterpoint claiming a weakness in Microsoft's prospects. As this article proceeds, I hope to guide the reader through the maze.

THE GOOD, THE BAD AND THE UGLY

Before I expound on the company's strategies and prospects, let us take a quick look at relevant metrics.

FINANCIAL STRENGTH (MRQ)

CURRENT RATIOQUICK RATIOLONG TERM DEBT
3.23.10.2

MANAGEMENT EFFECTIVENESS (TTM)

ROAROEROI
16.17%28.93%21.08%

GROWTH

EPS (TTM/TTM)SALES 5 YEARS
48.51%5.20%

Information gleaned from S&P CAPITAL IQ

Move along now, nothing to see here! At least nothing that would deter an investor from delving further into Microsoft.

Microsoft outlined a clear and ambitious plan for moving ahead. The introduction of Windows 8.1, the acquisition of Nokia, the debut of Xbox One and Microsoft's investment in Cloud services are all pieces in a grand puzzle. All are part of a future milieu Microsoft hopes to craft.

THE GOOD

OPERATING SYSTEMS

Microsoft's cash cow, Microsoft's moat, has always been its operating systems. At the height of the Windows XP cycle, it was the most popular operating system in the world. Over 800 million computers utilized Windows XP, and today 39% of users still rely on XP for their computing needs.

On April 8, 2014, Microsoft will no longer provide support to Windows XP. When Microsoft's support ends, any company or individual using Windows XP does so at their own peril. The sharks are circling, and on April 8, there will be blood in the water. Hackers will relentlessly attack computers operating with the once vaunted, now archaic, Windows XP system.

Even with this doomsday of sorts rapidly approaching, multiple studies indicate businesses are lagging in the transition to newer operating systems. Corporations will be loath to transition to a system other than one anchored by Microsoft. New training and equipment are costly and time consuming. The coming transition translates into future profits for Bill Gate's team.

Meanwhile, Office 365 Premium, the company's subscription version of Office, has recorded impressive sales. Launched approximately one year ago, Home Premium now has 3.5 million subscribers, an increase of 1.5 million since May of 2013. According to John Case, vice president of marketing for Microsoft's Office Division, Home Premium is "officially the best selling Office edition yet."

At $99 per year, the new service received excellent reviews and stands to provide a steady stream of income to the company.

NOKIA

In a deal worth $7.2 billion, Microsoft acquired Nokia's handset and services business. One important aspect of the transaction was that it was funded by Microsoft's huge stockpile of offshore cash. Consequently, the funds available for share buybacks and dividend payments are not affected.

Microsoft hopes the new handset division will result in a positive cash flow by 2016. With a projected market share of 15% and revenues of $45 billion, Microsoft predicts a 2016 increase in EPS of .04 and profits of $299 million.

In the third quarter, Microsoft's Window Phones shipments jumped 156%, year over year. Windows phones posted the largest growth worldwide of any leading operating system.

In Europe, Windows phones neared a double-digit market share. With a 16% share in Italy, 12.9% share in France and market shares of 10.8%, 5.7%, and 4.8% respectively in the UK, Germany and Spain, Microsoft handset related products enjoyed their highest sales share to date on that continent.

The increase in Windows Phones is largely driven by the Nokia Lumia 520. With a price point that appeals to entry level buyers, the 520 accounts for close to 40% of the 30 million Windows phones purchased in 2013.

Microsoft now claims to have out-shipped the iPhone in 24 markets while gaining a position as the number two mobile operating system in 14 countries.

CLOUD SERVICES

The impressive growth of Azure and Office 365 cloud services are beginning to rev up Microsoft's bottom line.

By providing a cloud computing platform and infrastructure which allow users to build, manage and deploy applications and services through Microsoft's global network of data centers, Azure has the potential to lure many corporate clients to Microsoft's cloud services.

Azure is particularly versatile in that it provides both PaaS and IaaS services and supports a wide array of programming languages.

In fact, the extent of Azure's features and services exceed this author's level of expertise and are beyond the scope of this article.

Compared to last fiscal year's comparable quarter, revenues in cloud services more than doubled. While Amazon (AMZN) is the current leader in the field, it appears that Microsoft can take advantage of their dominant position in business software to leverage themselves into business cloud computing platforms. It is only reasonable to assume that IT departments accustomed to dealing with Microsoft business products will view the transition as more comfortable and less fraught with peril.

Microsoft is moving ahead in this field with an investment of a $2.7 billion data center to be built in the Netherlands. Cloud services appear to be the wave of the future, and Microsoft is positioned to take advantage of the shifting tides in that arena.

In an initiative referred to as hybrid cloud computing, Microsoft is now using Azure in business software. Since Amazon currently lacks comparable business software products, this serves as a distinct advantage for Microsoft.

XBOX ONE

Playing games on the internet… a rather trivial pursuit, don't you think? Not in the eyes of Microsoft. I believe the average investor is overlooking the potential involved in the proliferation of Xbox One. It appears as a rather innocuous side-show in an enterprise as huge as Microsoft, yet there are those that view it as the cornerstone in Microsoft's growth plans.

Xbox One is off to a flying start, selling over 900,000 units last December and finishing first in sales during that crucial holiday month. The precursor to Xbox One, Xbox 360 finished a strong third behind PlayStation 4, with 643,000 units sold the same month. Consumers purchase an average of 2.9 games for every Xbox sold. Total combined spending on Xbox consoles and games in December reached $1.39 billion, equaling fifty percent of the software, hardware and accessories sales in the U.S.

The Xbox One received glowing reviews, but as I stated before, there is more here to consider. Xbox One is far more than a gaming system. The owner of an Xbox One can plug their cable box into the console and control it with Kinect. Consequently, Xbox One can control both your TV and serve as a gaming console. With picture in picture and voice controls, it operates as a platform for media distribution, as well. Herein lies potential for enormous profits for Microsoft moving forward.

THE BAD

THE WEAK SERVER MARKET

The worldwide server market declined 3.7% in the third quarter. Microsoft's server demand also declined, although to a lesser degree.

THE PC MARKET DECLINE

Microsoft made their profits and built their business by supplying operating systems for computers. In 2013, global PC sales suffered a 10% drop, the worst decline in the market's history. This setback followed a previous record decline of 3.9% in 2012. The 6.9% drop in the fourth quarter marked the seventh consecutive quarterly loss in PC shipments. Surely this doesn't bode well for a corporation so dependent on PC sales.

However, there are those who believe the PC market is stabilizing. Intel CEO Brian Krzanich considers demand for Intel chips as an accurate barometer of the PC industry as a whole. According to Krzanich, his company sold 7% more desktop PC chips in the fourth quarter.

MICROSOFT'S ANEMIC TABLET SALES

To call Microsoft's share of the tablet market as small is akin to describing a Munchkin in The Wizard of Oz as short. From a 0.9% share in 2012 to a 3.4% share in 2013, this initiative won't push Microsoft's stock price much higher. Incremental growth in Microsoft's tablet sales are projected to result in a 10.2% share by 2017, but tablet growth is viewed as a declining market as consumers move to phablets and smartphones.

NOKIA

Although Microsoft is expanding their share of the market with Windows Phones, Nokia's fourth quarter financial results were less than spectacular. Moreover, Nokia sales lag badly in China and Japan. Microsoft is aiming for 15% of the global market, a share of phone sales equal to Apple's (AAPL). Meanwhile, rumors abound that Microsoft is considering alliances with the likes of Samsung (OTC:SSNLF) and Sony (SNE) to augment their share of the smartphone market. Until Microsoft hits a minimum of 50 million in smartphone sales, losses in that segment will continue.

CLOUD SERVICES

Amazon is the undisputed leader in cloud services, and there is a gaggle of other innovative companies jockeying for position in this arena. Amazon's share of the cloud market is estimated as five times that of other competitors combined. Aside from the broad range of services offered, Amazon is constantly expanding their services and reducing prices.

XBOX ONE

While there are those who favor the Xbox One, others point to a variety of problems with the product. The combined cost of all parts associated with the manufacture of the Xbox One total $471. Since the Xbox One sells for $499, I'm going to take a wild guess and say it isn't a profitable product. (Let us look. Yep, I'm right). Rick Sherlund, analyst for Nomura Securities, issued a report on November 25, 2013, which estimates that after research, development, sales and marketing expenses are added to manufacturing costs, Xbox One will result in a $1 billion loss for Microsoft.

LAST QUARTER'S RESULTS. GOOD? MAYBE.

There are those who believe the good news in Microsoft's recent quarterly statement was unimpressive. Most of what they cite as a less than stellar performance is summed up in my "BAD" section. In essence, there are those that believe Microsoft's positive earnings surprise came from one-time boosts, cost cutting and weaker product lines that cannot drive future growth.

THE UGLY

This is really pretty ugly. By that I mean, this is ugly, but it is also pretty.

Apparently Google (GOOG) unlawfully used technology developed by Microsoft and others to create the Android and Chrome operating systems. Now Microsoft is stepping in to enforce patent claims. Faced with expensive and lengthy lawsuits, nearly two dozen Android manufacturers signed licensing agreements with Microsoft. Microsoft's income from the resultant royalty fees are estimated at $430 million to $3.4 billion in 2013 alone. Moreover, estimates for 2017 range from $5.7 to $8.8 billion.

CONCLUSION

A perusal of this article could leave one with questions as to Microsoft's future prospects. However, if Microsoft's profitability and growth were foregone conclusions, those prospects would already be baked into the stock's price. It is only in accurately measuring the potential of a company that we as investors stand to make outsized gains.

I believe in Microsoft and I've "put my money where my mouth is." I'll go on record as stating I executed an entry level position at 36.63 per share on 01/29/14. I hope to at least double my position in the coming weeks. (I say hope because my Uncle Sam and Cousin California are visiting me on April 15th. They are a couple of freeloaders and have voracious appetites, so my cash flow may suffer for the short term).

Herein is my rationale for purchasing Microsoft.

Microsoft's Office 365 Premium subscription program will result in a continuous, reliable and profitable revenue stream.

I believe Microsoft is taking measures to adapt to a changing market. While they may have lagged in the past, each of the company's initiatives is making impressive inroads measured by increased market shares in every category.

Microsoft's $60 billion in cash allows for missteps by the company. If its business plan is faulty or the company in its execution, Microsoft's resources can prevail.

The company's entry into cloud services will prove highly profitable. While Amazon holds a large lead over Microsoft in that arena, Microsoft has many long-term partners in the business world. It is reasonable to assume those companies will opt for Microsoft as they make their transition into cloud services. Furthermore, Microsoft should be able to utilize Azure, Office 365 and Xbox One to leverage themselves into a leadership position. Furthermore, Microsoft may use its $60 billion cash pile to overwhelm the competition.

Microsoft has a solid history of share buybacks. The total number of shares outstanding dropped from 10.8 billion in 2004 to 8.3 billion in 2014. With a newly authorized $40 billion share repurchase program, it is estimated that Microsoft will buy back 13% of the company's float in the next few years. In addition, unlike many share buyback programs (a favorite complaint of many investors) Microsoft's purchases are occurring while the shares are at a reasonable value.

With a PE ratio of 13.5, I believe Microsoft is a classic example of a company that is temporarily out of favor with the market.

Microsoft boasts a good dividend with a reasonable pay-out ratio and a history of hefty dividend increases.

And last but not least, last April, ValueAct disclosed a $1.9 billion stake in Microsoft. It is believed ValueAct will pressure Microsoft to increase dividend and share buyback programs.

With a dividend north of 3%, a history of hefty dividend increases and share buybacks, a P/E of 13.5, a considerable business moat, enormous resources in the form of cash and cash equivalents, and growth prospects, Microsoft offers everything one could desire in a stock. So to all of my friends in the DGI community, buy Microsoft before it becomes a Dividend Aristocrat.

Source: Microsoft: For DGI And More