Why Microsoft's Turnaround Is Just Getting Started

| About: Microsoft Corporation (MSFT)


Microsoft has made huge gains in cloud-based software and services.

Even Microsoft's gaming hardware business is profitable.

The company generates strong free cash flow, which should provide for a big dividend increase soon.

Just a few years ago, there were very real concerns that technology giant Microsoft (NASDAQ:MSFT) was about to become a relic. Analysts and investors alike were seriously worried that Microsoft's continued reliance on the personal computer was akin to being aboard a sinking ship. In the financial media, many observers speculated that Microsoft would see its cash cow software lose prominence in the post-PC era.

But that simply hasn't happened. Microsoft has kept growing through all of the negative sentiment. The reasons are that the company has made huge strides in the cloud, and has even turned around its hardware business. For these reasons, it's likely the company has a lot of growth left in store.

A new day for Microsoft

Over the course of 2014, Microsoft has put up great numbers. It recently concluded its fiscal 2014, and the results were impressive. Revenue and diluted earnings per share grew 11.5% and 2%, respectively, for the full year. Profits were weighed down by some non-cash items, so its free cash flow still looks good. Microsoft generated $26.7 billion in free cash flow in fiscal 2014, up nearly 9% from the prior year.

Microsoft does a great job of returning a lot of this cash flow to investors. Last year, Microsoft paid $8.8 billion in dividends and bought back $7.3 billion of its own stock through share repurchases.

The reason why Microsoft is still generating so much cash, even though so many were negative about the company's prospects, is that it has made huge gains in the cloud. Microsoft is no longer chained to the personal computer, as many assumed it would be. Newly-appointed Chief Executive Officer Satya Nadella pointed out in the earnings release that Microsoft's commercial cloud revenue doubled last year, to $4.4 billion. Specifically, its Office 365 and Azure cloud offerings doubled revenue during the year.

Making progress in hardware as well

Not only has Microsoft grown thanks to its cloud-based offerings, it's also drastically improved its hardware business. Its new Xbox system, the Xbox One, has not only sold well, but it's also turning a profit for Microsoft, which it didn't used to do.

When Microsoft released the previous iteration of its gaming console, the Xbox 360, it wasn't profitable. Even though Microsoft sold millions of its Xbox 360 devices and generated billions in revenue, Microsoft reported operating losses totaling more than $3.2 billion in its entertainment and devices division in 2006 and 2007 combined, according to the company's 10-K documents from those years.

But in fiscal 2014, Microsoft turned an $893 million profit in computing and gaming hardware. It's a great sign that Microsoft is finally making money from its gaming business.

Big rewards for investors

The end result is that Microsoft has a rare ability to generate tons of free cash flow, maintain a rock-solid balance sheet, and return a great deal of cash to investors. At recent prices, Microsoft's dividend yields 2.6%.

Microsoft has increased its dividend by 16.5% compounded annually over the past five years. It's been one full year since Microsoft last increased its dividend, so investors should fully expect another increase in time for its next quarterly payout.

And, since Microsoft will generate plenty of free cash flow and has a habit of strong increases, investors should expect another double-digit dividend increase.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.