Microsoft: Dynamic Dividend Growth Potential

Summary

• Microsoft has been one of our favorites for some time.
• The company has demonstrated both the capacity and willingness to keep raising its dividend payout, and we think this will continue.
• Microsoft is what we might call a Dividend-Aristocrat-to-Be, as we expect management to keep raising the quarterly payout each and every year.
• Investors should still be cautious about Microsoft's valuation as even the high end of our fair value range doesn't imply too much upside.

By The Valuentum Team

We've liked Microsoft (NASDAQ:MSFT) for a very long time. There were few other companies, in which we've had greater conviction these past many years, and we wanted to share a little bit of our history with the name. A look at our archives on the company is something else. In October 2011, we said, "Microsoft Remains a Steal At These Levels," and we followed up in December of 2011: "Microsoft: Undervalued, Boasting Best-in-Class Yield," and then again in January of 2012, "Microsoft's Valuation and Dividend Prospects Make It Best In Breed." We pounded the table time and time again in the years following, too.

We hope this helps set the context for the note behind how much, and how long, we have liked Microsoft. We're not biased to liking the company. We just love financial analysis and put a considerable emphasis on the cash flow statement and balance sheet. That said, we have to admit that we weren't as excited as we maybe should have been with the LinkedIn deal, as we are so laser-focused on economic value add, but we think that tie-up will work itself out in time. It's hard to find great assets at cheap prices, but that's what investing is all about. Microsoft has solid competitive advantages, considerable free cash flow generation, and a very healthy balance sheet.

Hard Not To Like Microsoft's Operating Performance

Image Source: Microsoft fiscal second-quarter 2018 slide deck

At the end of January, Microsoft reported very strong fiscal second-quarter 2018 results. Total revenue growth was amazing at the company, with the company posting 15% growth in 'Intelligent Cloud' revenues. Microsoft held the line with gross margin in the period, but it managed to drive operating income 10% higher. It's hard to be disappointed with that performance, but we were probably even more excited by its free cash flow generation. Microsoft generated a very-strong $5.3 billion in free cash flow during the quarter, up 23% on a year-over year basis. Better working capital management and strong billings growth were the key drivers behind the successful cash-flow conversion. Free cash flow growth of 20%+ is quite the achievement.

Image Source: Microsoft fiscal second-quarter 2018 slide deck

On the fiscal second-quarter 2018 earnings call, Microsoft offered some very encouraging guidance. Revenue expectations of $25.6 billion for the fiscal third-quarter of 2018 were ahead of what consensus had been expecting at the time, and expectations for fiscal year 2018 operating margin to be up slightly for the year was in-line with what many had been expecting (though the executive team at the time noted that both gross margin and operating margin were trending ahead of its internal expectations). Importantly when it comes to the outlook, Microsoft noted that there are "positive IT spend signals, a strengthening commercial PC market, and growing customer demand for hybrid cloud services." The backdrop at Microsoft looks solid as the company moves into the back half of its fiscal year.

Microsoft's Dividend Health Is Fantastic

Image Source: Valuentum. Note: The table differs slightly from Microsoft's dividend history on its investor relations website due to the table above being based on the pay date of the dividend and the investor relations website being based on the announcement date.

Let's first talk about Microsoft's capacity to keep raising the dividend. The company boasts an impressive balance sheet with a net cash position of ~$57 billion as of the end of calendar 2017 ($142.8 billion in total cash, cash equivalents and short-term investments and $85.8 billion in short- and long-term debt). Though its recent acquisition of LinkedIn for $26.2 billion had a big price tag, Microsoft continues to believe the deal will expand its addressable market, while helping to drive engagement across Office 365. As we hinted at earlier, however, we're not exactly fond of what the deal means for Microsoft's future dividend potential, given the price tag and LinkedIn's lack of a strong operating track record. We tend to focus too much on the risks, however, and we don't want readers to think Microsoft is not still one of our favorite dividend growth ideas.

Image Source: Valuentum

The image above reveals the numerator and denominator of what we call the Dividend Cushion ratio. At the core, the larger the numerator, or the healthier a company's balance sheet and future free cash flow generation, relative to the denominator, or a company's cash dividend obligations, the more durable the dividend. In the context of the Dividend Cushion ratio, Microsoft's numerator is larger than its denominator suggesting strong dividend coverage in the future. The Dividend Cushion Ratio Deconstruction image above puts sources of free cash in the context of financial obligations next to expected cash dividend payments over the next 5 years on a side-by-side comparison. We think it is a good measure of a company's capacity to keep paying and growing the dividend.

Because the Dividend Cushion ratio and many of its components are forward-looking, our dividend evaluation may change upon subsequent updates as future forecasts are altered to reflect new information. Still, one can see in the image just how much wiggle room Microsoft has to keep growing the payout, beyond even our expectations for continued payout expansion. The numerator divided by the denominator equals 3.3, or what we would say is Microsoft's Dividend Cushion ratio. What we find really interesting about the magnitude of this ratio is that Microsoft's cash dividend payments aren't insignificant. The company has a dividend yield just shy of 2%, so it's no small dividend payer. In fact, it stacks up pretty well against the average S&P 500 company.

When it comes to willingness to keep raising the payout, we heard all that we needed to during the company's fiscal second-quarter conference call in January. Management is committed to capital return through both dividends and share repurchases, and while Microsoft did have to take a $13.8 billion net charge related to tax reform ("Tax Cuts and Jobs Act") in the most recently-reported quarter, we think a lower tax bill in the long run will only further aid the company's ability to meet its dividend obligations. We believe Microsoft is what we might call a Dividend-Aristocrat-to-Be. It seems like it is just a matter of time before the company accumulates enough consecutive years of dividend increases to meet the criteria of a Dividend Aristocrat.

Conclusion

Image Source: Valuentum

Image Source: Valuentum

We spend a lot of time calculating fair value estimates, which differ from price targets, "How Well Do Fair Value Estimates Predict Stock Prices." Remember how we saw a considerable valuation mispricing in Microsoft a number of years ago (the links in the introductory paragraph)? At a high level, price targets reveal the price at which an analyst thinks a stock may trade in the near term, while fair value estimates focus on the long-term cash-flow generating capacity of the entity. They are not the same. We value shares of Microsoft at $87 at the moment, a little conservative perhaps, but even the high end of our fair value estimate range ($104) doesn't leave too much room for a continued share-price advance. We're not saying that there can't be valuation upside; we just think investors should be cognizant that its valuation is not as attractive as it once was many years ago.

That said, we're really excited about the dividend. The latest dividend increase at Microsoft came in September 2017, with the company upping its quarterly payout $0.03 per share, or ~8%, at the time. This hike followed a prior $0.03 increase, another ~8% jump, in September 2016, and we're looking forward to another meaningful bump in September 2018. Though we're modeling in a $0.05 per share increase for fiscal 2018, we think investors are very comfortable with the current $0.03 per-share annual pace. If CEO Satya Nadella is reading this, it looks like Microsoft is in great shape to keep raising the payout at a more aggressive rate, but we certainly understand how a more-cautious steady climb may be more prudent, especially more than 9 years into the current bull market. Any increase above a $0.03 quarterly per-share hike may be viewed as an upside surprise.

This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.

Analyst’s 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.

MSFT is included in Valuentum's simulated Dividend Growth Newsletter portfolio.