Microsoft's Buyback Paves The Way For High Dividend Growth

| About: Microsoft Corporation (MSFT)


Microsoft is retiring 3.5% of its outstanding stock each year as part of its buyback program.

The company has $84 billion in cash assets and a dividend payout ratio below 40%.

Core business profits are growing at 6% annually, which sets the stage for double-digit dividend growth when you adjust for the growing payout ratio and robust buyback program.

Since 2006, Microsoft (NASDAQ:MSFT) has used its large cash hoard (now totaling almost $84 billion in cash assets) and growing profits to start buying back large amounts of stock. The share count has declined from 10.1 billion to 8.3 billion, and this 18% reduction in the share count is especially impressive considering that Microsoft has used its stock as a currency during acquisitions.

Currently, Microsoft is in the beginning stages of its authorization to repurchase $40 billion worth of the company's stock (the time period to buy back the stock is indefinite). At a current market capitalization of $326 billion, the share repurchase plan is an authorization to buy back up to 12.26% of the company's outstanding stock.

The company has discretion to determine the amount of stock that gets repurchased each year. Assuming normal operating conditions, Microsoft should repurchase about $11 billion worth of its stock in a given year (that's based on using 2011 as a "normal year" in which money set aside for discretionary buybacks that don't get diverted to fund acquisitions). At that pace, it will take Microsoft about four years to complete its buyback authorization, retiring about 3.5% of the outstanding stock per year.

When you're looking for high dividend growth, there are generally three conditions that (if they all exist simultaneously) create fertile soul for rapidly increasing payouts: strong buybacks, strong organic growth and an increasing payout ratio.

Microsoft can currently check off all three. In addition to buybacks that reduce the share count by about 3.5% annually, the core business is growing at about 6% annually. A lot of this is driven by the consumer licensing division (which accounts for a little more than half the company's profits) which has absurdly high margins in the 50% range. Revenues have been increasing coming out of the recession (2010-2013) at a pace of 9.0% annually, which has made it easier for the company to focus on long-term research and development rather than trying to "force" the revenue growth to translate into commensurate earnings growth (note: the company currently has a research budget that is 12-13% of its 2013 revenues).

That brings us to our third element: payout ratio. Ever since initiating a dividend in 2003, Microsoft has been gradually increasing its payout ratio by paying a dividend that has been growing faster than its earnings per share growth rate. From 2003 through 2008, the dividend constituted roughly 10-25% of profits. By 2013, the dividend inched up toward 33% of profits.

The company generally needs to keep about $7 billion worth of annual profits on hand to fund future growth. The company's net profits, however, are a little over $22 billion. The current dividend commitment is at about $9.5 billion. In other words, the company has about $5.5 billion in annual profit that can either go toward buying back stock or adding to the company's already swelling $80 billion cash hoard. That $5.5 billion gap, however, also represents Microsoft's ability to increase its payout into the future. And because the company is retiring its share count by 3.5% annually, this $5.5 billion will actually be divided among a fewer number of shares outstanding.

Since its initial dividend declaration in 2003, Microsoft's dividend growth rate has been excellent. The dividend doubled in 2004 and again in 2005, grew between 10-15% from 2006 through 2009, took a breather in 2010 when it only grew 5.7%, and has grown by over 20% annually since then. Despite this, Microsoft's payout ratio still hasn't breached 40% of total profits.

Simply put, Microsoft is set to continue growing dividends at 10% or higher for the medium term. The company has $84 billion in cash assets. It is increasing earnings per share by 3.5% annually through its buyback program alone. It has core profits growing at 6% annually. In addition to this, the payout ratio is only 40% of profits and the company has $5.5 billion in annual profits that do not need to be retained for future growth nor go toward Microsoft's pre-existing dividend obligations. All of these factors combine to ensure that Microsoft investors will be rewarded with a high dividend growth rate over (at least) the coming five-year period.

Disclosure: I am long MSFT. 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.

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