What Does Microsoft's Capital Return Program Mean For You?

| About: Microsoft Corporation (MSFT)
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Microsoft recently announced its new capital allocation plans.

The company has built up a rather impressive record of paying dividends and utilizing share repurchases in the past.

This article looks at what the most recent announcement could mean for today’s shareholder.

On September 20th of 2016, Microsoft (NASDAQ:MSFT) announced a quarterly dividend of $0.39 per share - representing an 8% increase over the prior mark - to go along with a new share repurchase authorization of $40 billion. The new program has no expiration, and will follow the current program, which is anticipated to be complete by the end of 2016.

Incidentally, this leads us into a nice bit of press release history when it comes to the Microsoft's capital return program. In September of 2013, Microsoft announced a $0.28 quarterly dividend (representing a 22% increase over the prior mark) to go along with a $40 billion share repurchase program (the one that's about to be completed).

In September of 2008, Microsoft announced a $0.13 quarterly dividend (an 18% increase) to go along with yet another $40 billion share repurchase program - this one went from 2008 through 2013.

In July of 2006 Microsoft had a $20 billion tender offer.

And the big announcement was back in 2004, when Microsoft announced a $0.08 quarterly dividend, a $3.00 special dividend and $30 billion worth of share repurchases over four years.

There has been no shortage of funds going toward dividends and share repurchases over the years. On the dividend side Microsoft has been making cash payments dating back to 2003 and raising this mark regularly year-after-year; earning the company "Dividend Achiever" status.

The dividend started out as a small portion of earnings (~8%) but the payout ratio has now jumped up to nearly 50%. This has allowed for exceptional past dividend growth, but perhaps offers a slightly more cautious view moving forward.

On the share repurchase side you can see tremendous improvements over the years. Let's just take a look at the past decade. At the end of fiscal year 2006, Microsoft had just over 10 billion common shares outstanding. By the end of fiscal year 2016, this number had been reduced all the way down to 7.8 billion - or a compound average annual decline of about 2.5% per year.

This allowed the underlying earnings claim of continuing shareholders to grow faster than the business as a whole. The business grew company-wide earnings from $12.6 billion to $22.3 billion - an impressive 77% during this period. Yet earnings-per-share grew from $1.20 to $2.80 or a total gain of about 132%.

Of course all of that is in the past. Let's think about the potential shareholder results, as it relates to the current capital return program, for a Microsoft shareholder in the coming years.

The first thing to consider is how long it might take Microsoft to "use up" the current share authorization. Over the years Microsoft has allocated an extraordinary amount of funds toward share repurchases. During the past decade, the average amount of funds going towards this endeavor have been about $12 billion annually (although the number drops to an average of "just" $8 billion once you take into consideration stock issuance and compensation).

When you look up "MSFT" on a financial website, you might see the dividend yield listed, but the capital returns have been just as much share repurchase heavy. As a point of consideration, the average amount spent on dividends during this same time was about $6.5 billion per year. Indeed, in only three out of the last ten years have dividend payments been more than the total spent on share repurchases.

With this in mind, you'd want to think about a reasonable share repurchase assumption - for our purposes we'll use $8 billion annually for four years. That bakes in conservatism in two ways: perhaps extending the length of time necessary and discounting the $40 billion headline number down to $32 billion.

Now your future returns are naturally dependent on the business performance of Microsoft and how other shareholders respond to that performance. Neither situation is known, but as an illustration we can work with a baseline.

For earnings expectations I have seen intermediate-term growth estimates ranging from 7% to 10%. Let's scale it back a bit and call it 5% company-wide earnings and dividend growth over the next four years.

I'll jump over the in-between math and get to the punch line.

If Microsoft is able to grow by 5% per year and shares continue to trade near the current valuation, you might anticipate the company retiring ~480 million shares or thereabouts. Just to give you a reference point, from 2012 through 2016 Microsoft reduced its share count by about 570 million shares.

This reduction would allow earnings-per-share and dividends per share to grow at a faster rate than company wide results. You could anticipate receiving $6.40 or so in cash dividend payments, to go along with a future earnings-per-share number near $3.65. Your expected annualized return would be around 8% per annum.

Now this is if things stay as they are. Yet the valuation could end up being a lot higher or lower.

If shares instead traded with an average P/E ratio of say 24, Microsoft would not be able to retire nearly as many shares - "only" 400 million or so. Consequently, your earnings and dividend per share growth rates would decline as well. Yet the much higher multiple (and thus share price) would easily make up for this - implying total returns near 13% per annum.

On the other hand, if shares were to trade with an average valuation of say 16 times earnings, Microsoft would be able to retire a whole lot more shares - around 600 million. In turn, the per share growth rates would be faster. However, the P/E compression would stymie returns to the tune of 3% per annum.

The takeaway is twofold. First, Microsoft is likely to retire ~5% to ~8% of the current outstanding shares in the next few years. This will allow a shareholder's underlying earnings and income claim to increase at a greater rate than the business.

Second, the potential returns that this might represent depend greatly on whether or not you believe today's valuation offers a "fair shake." If the current valuation holds (or increases) you could easily see high single-digit or low-double digit gains - even with average business results. On the other hand, if today's valuation is "too high," the outsized share count reduction and dividends probably cannot "save" an investor from average or lackluster returns.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.