In my search for stocks that will provide a reasonable upside and have limited downside, I turned my attention to Microsoft (NASDAQ:MSFT). My teenage son kept talking about a new Xbox, my in-college daughter just purchased (for the second time... with my money) Office 365, and the chart for the last twelve months looked exciting. If truth be told, I am looking for love in the market. I think my dear friend, the S&P 500, in her many guises, (NYSEARCA:SPY) (NYSEARCA:IVV) (NYSEARCA:VOO), is getting a little rich for my blood. I was prepared to fall in love with MSFT. Unfortunately, what I saw instead was AT&T's (NYSE:T) younger sister. And while AT&T is an admirable lass, who has served many a family well, often for generations, she is a plain girl and a bit of a homebody. I am looking to partner with a spryer stock, a stock that does not know how beautiful and talented she is (please forgive the sexism), and most importantly, a stock that is not expensive to date! A total return stock.
Older Sister and Younger Sister
Both MSFT and T are members of the Dow Jones Industrial Average, whose components are the bedrock of American business and are updated for relevancy (look for Apple (NASDAQ:AAPL) to be added this year or next). Both companies have similarly large enterprise values, $308 billion for MSFT and $253 billion for T. Both companies have paid sizable dividends which increase annually, MSFT since 2003 and T since, well basically forever (1984, when it began in its current iteration as Southwestern Bell). Both generate tons of operating cash flow, $32 billion for MSFT and $34 billion for T (Source: Capital IQ). Basically, both companies are living off of and to their respective credit, maximizing the value from their cash cows. Of course, in MSFT's case, it is the Office suite and the Windows operating system that is the primary source of profits and for T it is the wireless and wirelines businesses.
For a slower growing Company (7.5% projected growth over the next five years), MSFT's valuation is, how can I put it, high! The Company's PE is 16.5x forward, and its PEG (PE/Growth) is a sky-high 2.2. MSFT's dividend is a respectable, but not eye-popping, 2.5%. However, compared to peers, MSFT is higher in PE (even compared to 11.8% expected growth of AAPL) and PEG.
As the below chart highlights, MSFT will get closer to T's PE valuation in 2016, while catching up to, but still lagging in dividend yield. However, MSFT's dividend has been increasing at a very healthy +/-20%, compared to the anemic 2% T has been growing in recent years. As I said at the outset, MSFT is still T's younger sister and still has some catching up to do!
Last year at this time, MSFT's PE was 12.3x and it paid a 2.8% dividend; of course, last year I was not looking for a new relationship, so I missed out. Only in the last twelve months has MSFT performed well, gaining over 35% and outdistancing T (and the S&P 500) by a wide margin.
For the four years prior, MSFT and T performed roughly equally (excluding T's superior dividend) and both performed roughly half as well as the S&P 500.
MSFT has been searching for the fountain of youth, to grow once again. Strategies like turning the Office product into a subscription and cloud model will not bring back the 1980s, but are spot-on. The strategy leverages a core product, makes it appear "affordable" on an annual basis, while garnering incremental revenue over the product's life (also taking into account the longer replacement cycle for computers) and perhaps discourages bootlegging.
MSFT's new CEO, Satya Nadella, is a welcome change from Steve Ballmer, focusing on speed and efficiencies. MSFT's strong price appreciation has coincided with his appointment. However, one man, while improving the Company at the margins, is not going to remake an entity whose huge profits are the result of a legal monopoly. Further, the Company's culture, proven many times over the years, is not at the leading edge, it is middle-of-the-road.
It appears MSFT's stock, on the back of Mr. Nadella's appointment, has combined three years of appreciation into one year. If this were 2016, MSFT would be fairly valued.
Flushing the Failures Out
While no one can deny Steve Ballmer tried hard, he really failed to grow MSFT beyond its core products. The acquisition of Nokia had a "Hail Mary" feel to it, and thankfully it is getting flushed through the system (write-offs, layoffs and divestitures. The Surface tablet has also failed, even with a ton of advertising behind it; expect it to be marginalized or shelved soon.
A Word About Xbox
Xbox is the one non-software innovation MSFT has nailed. I expect it to migrate with the industry to the cloud, while still leveraging the hardware. However, in 2014, computing and gaming hardware (Source: Microsoft 10-K) only generated $893 million in gross margin. Profitable? Absolutely! Enough to move the needle? No (even at 2012 levels of $2.5 billion in gross margin)!
The Search Goes On
So, after going for coffee, it is safe to say I will not be dating MSFT for at least a couple of years. The Company is strong, it is doing the right things and dividends are rapidly increasing. However, it has simply gotten ahead of itself with respect to valuation. On multiples, compared to its peers and its "big sister", T, the Company is expensive. MSFT really looks like it is a latter-day T, the Company has a strong position in its core products, generates a ton of cash, is constantly trying to make its future brighter, and, of course, it is turning into a dividend champion.
I see MSFT as a marvelous dividend (and potentially a total return) stock at the end of fiscal 2016. By that time, the PE will have moderated and the PEG will be more reasonable. At the end of 2016, MSFT should be paying between $1.60-$1.65 in dividend, yielding 3.5%, or more.
Disclaimer: This article reflects the author's opinions and is not meant to be the basis of an investors' buy or sell decisions. All investors should conduct their own due diligence and make investment decisions solely on their research.
Disclosure: The author is long APPL. 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.