This is the third in a series of articles that is looking at high-profile technology stocks as growth and dividend income selections. Our first article in the series laid a general framework around 10 high-profile technology stocks as dividend growth candidates. Additionally, our first article also covered Intel Corp. (INTC) and Taiwan Semiconductor (TSM) more specifically and can be found (here). Our second article featured Harris Corp. (HRS) and KLA-Tencor Corp (KLAC) and can be found (here).
With this, the third article in this series, we will look at the "essential fundamentals at a glance" of two high-profile technology stalwarts, Microsoft (MSFT) and Honeywell (HON). From the table below, it can be seen that they rest in the middle of our 10 selections regarding dividend yield. But, as one of the primary underlying themes of the series has focused on, similar statistics can be found among very dissimilar companies. This is why we believe a clear graphical rendition of a company's operating history is so valuable. As we will soon see, a picture offers distinctions that tables of numbers are not capable of providing.
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Microsoft Corp. and Honeywell International
Although neither of these two technology stalwarts requires much of an introduction, we will provide a brief description on each. We will utilize the F.A.S.T. Graphs™ (Fundamentals Analyzer Software Tool) historical graphs in order to learn as much as we can about the past operating successes of each of these businesses. Then, we will utilize forecasting tools and graphs to run possible scenarios on future operating results.
Consequently, we will attempt to learn as much from the past as we possibly can, but our main focus will be on looking toward the future for these two technology blue-chips, and on what investment benefits they might offer prospective investors. A secondary objective of this analysis will be to help investors determine if a more comprehensive research effort is warranted on either of these names at this time.
"Founded in 1975, Microsoft (Nasdaq "MSFT") is the worldwide leader in software, services and solutions that help people and businesses realize their full potential. "
Microsoft reported earnings on January 19, 2012 and here is a link to the earnings call transcript (here).
The following historical graph plots Microsoft's earnings and dividends only since 1993. As we will show later, Microsoft's stock price performance has been rather poor after becoming significantly overvalued in calendar year 1999. However, a quick glance at the earnings record shows that the company's business results have generally been consistent and strong with earnings growth averaging almost 20% per annum (19.6%).
Notice that the drop in earnings for fiscal years 2001 and 2002 can be attributed in great part to the unsustainably large earnings growth rates in fiscal years 1999 and 2000. Much of this growth can be attributed to the so-called Dot-Com explosion. The subsequent falloff had a great deal to do with the bursting of the Dot-Com bubble mania. Microsoft was selling a lot of software to a lot of Dot-Com startups that soon went out of business because of unrealistic business models. Consequently, what we really see is a short-term bubble (a temporary bulge) with Microsoft's earnings that reverted back to trend line growth once the insanity abated.
However, after the aforementioned bubble burst, you can clearly see that Microsoft instituted a dividend policy in calendar year 2003 (blue shaded area). The big spike we see in the blue shaded dividend area represents a special $3.00 per share dividend that the company paid in calendar year 2005. Otherwise, as we will see when we review performance results, Microsoft's dividends have increased every year since it instituted one in calendar year 2003.
Adding monthly closing stock prices and the normal PE ratio to the above graphic offers two very interesting and important insights. First of all, we can see how completely disconnected Microsoft's stock price had become relative to earnings justified valuation (the orange line). Therefore, a statistically (mathematically) calculated normal PE ratio of 30.6 represents a very misleading, although accurate, statistic.
Although the normal PE ratio of 30.6 is a trimmed (throwing out the high and the low) average for this 19-plus year time frame, it is clear from the picture that Microsoft's stock price had in truth rarely traded at a 30 PE. The extremely high PE ratios of 1995 to 2001, and partially evident again in 2002 and 2003, distort the average. On the other hand, a stock valuation significantly below a PE of 30 has been manifest since late calendar year 2004 to current time.
And finally, the great recession of 2008 created a sagging of both earnings and stock prices. Although stock price did quickly return to near its earnings justified valuation, price has mostly moved sideways since June of calendar year 2010. We feel this has created a significant undervaluation in the share price, while simultaneously offering up a temporarily higher than normal current dividend yield of 2.7% for this technology blue-chip.
By shortening our time measurement from 19-plus years to only the last 9-plus years, we discover that Microsoft's more recent earnings growth still averaged almost 15% per annum. However, we can also see that the headwinds of overvaluation (see red circle) have continued to hurt shareholder performance. We believe this represents clear and undeniable evidence of the importance of valuation. Even a great company like Microsoft producing strong above-average earnings growth cannot overcome an inflated stock price. High valuation destroys performance and increases risk.
When reviewing the associated performance of the above graph we discover clear mathematical evidence of how devastating overvaluation can be. Even though Microsoft's dividends increased every year, and even though they paid a special one-time $3.00 dividend in calendar year 2005, Microsoft shareholders still received rather anemic returns.
On the other hand, the power and protection of dividends are also clearly evident. Even though shareholders only earned $14,995 of profit on a $100,000 investment, the $24,561 in dividends more than doubled their total return. Nevertheless, the business produced above-average earnings growth while the stock, thanks to excessive valuation, produced below-average results for Microsoft shareholders.
Microsoft's current PE ratio is one of the lowest its been in many years, and perhaps finally reasonable. As overvaluation had such a deleterious effect on shareholder performance when valuation was high, can we assume that today's low valuation might produce the opposite effect?
Microsoft's current price to sales is also historically very attractive. This represents another metric that indicates attractive current valuation for this technology blue-chip.
The Future for Microsoft
As we have hopefully demonstrated thus far, reviewing Microsoft's historical price and earnings relationship provides invaluable perspectives. Because stock price performance has been so poor for so many years, we have seen a lot of Microsoft bashing, and listened to a lot of bias expressed by frustrated shareholders against this strong business. But no matter how good operating results have been, they have not been good enough to overcome such ridiculously extended prices. The reader should also consider that even though management does provide some control over business results, they have no control over how the market reacts to those results.
However, the most important point is that all investing is done in the future. Therefore, now that Microsoft shares are reasonably priced, it seems only logical to assume that if the company can continue to produce strong operating results, then future shareholder returns could be exceptional. It at least appears that the company's stock price is no longer fighting the headwinds of overvaluation.
As a further piece of reference, Microsoft's earnings per share growth since calendar year 2007 (the past five years) have averaged 13% per annum. This represents a modest reduction from the 15% 10-year average reported above, but consideration of the great recession should be taken into account.
Consequently, we don't believe it's a stretch to believe the consensus 10% five-year estimated earnings growth rate from 34 analysts reporting to Capital IQ . Furthermore, we believe that this kind of past, present and future growth is worthy of a PE multiple of at least 15. The Estimated Earnings and Return Calculator shows that if this were to happen, then the five-year estimated total return from owning Microsoft would equal 17.9% per annum, including dividends.
At its current price quotation, Microsoft's offers investors a very attractive 9% earnings yield. Additionally, a current 2.7% dividend yield is very likely to continue growing in the future as it has in the past.
Honeywell International Inc. History
"Honeywell is a Fortune 100 company that invents and manufactures technologies to address tough challenges linked to global macrotrends such as safety, security, and energy. With approximately 122,000 employees worldwide, including more than 19,000 engineers and scientists, we have an unrelenting focus on quality, delivery, value, and technology in everything we make and do."
The following historical graph plots Honeywell's earnings and dividends only since 1993. Here we see a clear picture of a company offering average long-term earnings growth with periodic bouts of cyclicality. Honeywell's operating history very closely mirrors the operating results of the S&P 500 (SPY). Even though earnings per share growth have only been average, we can see by the light blue shaded area that the dividend policy has been consistently applied. On the other hand, the dividend was frozen for calendar years 2000 to 2004, but the dividend was not cut during either of the last two recessions of calendar year 2001 or calendar year 2008.
In contrast to what we saw with Microsoft above, long-term earnings and price relationships of Honeywell have correlated very closely over the years. When we overlay monthly closing stock prices to earnings, we see that price has tracked earnings very closely with only short occasional periods where the two became disconnected. Furthermore, during the periods where stock price did become disconnected from earnings, it returned to its earnings justified valuation (the orange line) in short order.
Since calendar year 2003, we discover that Honeywell's earnings growth record of 8.3% has exceeded its 20-year average of only 6%. However, we continue to see a very close correlation between price and earnings. Consequently, the long-term history of how the market has treated Honeywell's earnings results provides a high degree of confidence that its price-earnings relationship should continue going forward.
Therefore, it seems only reasonable to assume that buying shares of stock in Honeywell makes sense when the price can be bought below the orange earnings justified valuation line as it is today. Most importantly, notice how undervalued Honeywell's shares were at the beginning of calendar year 2003, probably due to falling earnings for that year. In contrast to the negative effect of high valuation seen in Microsoft shares above, we will soon discover the benefits of undervaluation as we will see with Honeywell when we review the performance associated with the following graph.
When reviewing the associated performance with the above graph for Honeywell Corp., we discover that beginning undervaluation enhanced shareholder performance above what the company's operating achievement warranted. Thanks to undervaluation, Honeywell's 8.3% record of earnings growth translated into over 10% capital appreciation, to include above-average cumulative dividends paid, that swelled total return to just under 12% per annum.
As we have stated many times throughout this series of articles on dividend paying technology stocks, valuation does not only have an important impact on return, it also greatly impacts risk. It seems almost ironic that the lower risk provided by low valuation actually increases long-term total returns. This seems contrary to the notion that the only way to get higher returns is to take on higher risks. When the principles of valuation are adhered to, just the opposite occurs. Lower risks lead to higher returns.
Honeywell's current PE ratio is below its historical average. Consequently, it appears that Honeywell's current valuation is historically at a reasonable level.
On the other hand, Honeywell's price-to-sales ratio is currently about normal at 1.23 times sales. This valuation indicator represents valuation as neutral. In other words, Honeywell's current price to sales is neither an abnormally high number nor an abnormally low one.
Honeywell International - The Future
When looking to the future on Honeywell, we discover that most analysts foresee a significant acceleration in its earnings per share growth over the next five years. 20 leading analysts reporting to Capital IQ forecast five-year estimated earnings growth at 15.6%. Furthermore, checks at highly reputable sources such as MorningStar, Value Line and Zacks all corroborate earnings growth expectations of 13% to 15% or better. This accelerated expected earnings growth is one of the primary reasons that this historically average growing company made this list.
As has been the policy of this series of articles on technology dividend paying stocks, we will leave it up to each prospective investor's responsibility to decipher whether or not these earnings estimates are reasonable. However, assuming they are reasonable, investing in Honeywell shares at today's valuations seems to make a lot of sense. The calculated annualized total return over the next five years would be 18.5%.
Based on current expectations for earnings growth, Honeywell provides prospective investors an attractive earnings yield of 7%. Also, a 2.7% dividend yield with the potential to grow by 15% per annum would calculate to generating almost 2 ½ times the future income that the 10-year Treasury bond currently offers. Of course, there is a significant amount of risk as to whether or not Honeywell could achieve those objectives, while the Treasury bond yield is virtually a given. Nevertheless, there is at least the potential that investors would be compensated for the risk that they take.
After examining the past, present and future fundamentals of each of these two dividend stalwarts, it seems clear that they are both reasonably valued at today's levels. When measuring valuation and earnings growth, which these articles have presented as the two primary keys for long-term performance, Microsoft appears to offer the best valuation, and Honeywell the best expected future growth. Yet, when we add the two up; both companies are expected to offer approximately the same future total returns.
Since we're in the middle of our list of 10 technology stocks being featured in the series, it might be appropriate to mention here that technology in general appears to be a sector on sale. Therefore, we believe it makes a lot of sense that investors with a long-term time horizon might be wise to begin evaluating opportunities in this sector. In our opinion, this is even more appropriate considering that many technology stocks have begun paying dividends in recent years.
In conclusion, we emphatically state that although we believe the information presented in this article, and the other articles in this series, and it provides a comprehensive look at each of the essential fundamentals underpinning each of these companies, it should only represent the starting point for a more comprehensive effort. The primary objective should be to validate the accuracy of the consensus growth forecasts. Although we consider them a valid starting point, they are no substitute for doing your own due diligence. Moreover, perhaps this information provided will empower the reader to determine whether or not they are interested in conducting the additional due diligence necessary to properly invest.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.