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Microsoft’s One Downside


Published December 6th, 2016 by Bob Ciura

Microsoft Corporation (MSFT) has everything a dividend growth investor could ask for. It is a highly profitable company, with a well-defined growth plan, and an excellent balance sheet.

It also has an attractive dividend yield of 2.5%. And, it has delivered regular dividend growth.

Microsoft is a Dividend Achiever, a group of companies that have increased their dividends for at least the past 10 years.

You can see the entire list of all 273 Dividend Achievers here.

Plus, Microsoft has made huge progress in its business turnaround, thanks to emerging areas of growth like the cloud.

This has fueled impressive share price performance: Microsoft stock price is up 139% in just the past five years.

The only downside of Microsoft’s huge rally over the past few years is that it has elevated the stock’s valuation. This could limit future returns.

This article will review Microsoft’s fundamentals and its outlook.

Business Overview

Microsoft is a global technology powerhouse. It is the largest software company in the world. Its flagship software products include Microsoft Office and the Windows operating system. It also sells technology hardware, including the Xbox gaming console and the Surface tablet.

Microsoft was founded in 1975, and today operates in over 190 countries worldwide.

This is a challenging period for Microsoft. For most of its existence, Microsoft’s software was built for the personal computer. But the PC is in decline.

According to technology tracking firm IDC, worldwide PC shipments fell 3.9% last quarter.

As a result, Microsoft is looking towards a post-PC world. This is why it has developed its software for the cloud, called Office 365.

msft-cloud

Source: Deutsche Bank Technology Conference, page 2

It now provides its productivity and business process tools as cloud services.

This means consumers can access their software programs from anywhere and from any device.

At the same time, Microsoft is working to build what it calls the intelligent cloud. In the new era of the cloud, there is a great importance on data collection and storage. As a result, there will be much higher demand for data centers and servers moving forward.

Microsoft’s server products and cloud services include Microsoft SQL Server, Windows Server, Visual Studio, System Center, and Microsoft Azure.

Growth Prospects

Microsoft’s turnaround has seen its ups and downs. But it is making steady progress. Revenue fell 2% in fiscal 2016, as the company fights against the strong U.S. dollar, which makes exports less competitive in the international markets.

In addition, Microsoft still generates a significant amount of business from the PC. Declines in global PC shipments are a headwind for the company.

That being said, it is enjoying excellent growth in the areas that will fuel the company’s future. t saw strong growth across many of its other core businesses.

Last year, Microsoft’s commercial cloud segment became a $12 billion business in terms of annual revenue.

It has seen very positive momentum this fiscal year. Office 365 commercial revenue soared nearly 60% last quarter, year over year. In the same period, revenue from Azure jumped more than 100%.

Last quarter, Microsoft enjoyed continued growth across its focus areas. Revenue and earnings-per-share, adjusted for currency impacts, increased 5% and 13%, respectively.

msft-productivity-and-business-processes

Source: Q1 Earnings Presentation, page 7

Growth was led by the cloud once again. Commercial cloud revenue soared 54% in costant currency. Dynamics products and cloud services revenue increased 13%.

Server products and cloud services revenue increased 13%, driven by 116% growth from Azure.

Microsoft is also seeing good performance in devices, particularly in tablets. Surface revenue increased 39% last quarter, due to the Surface Pro 4 and Surface Book.

Going forward, Microsoft is banking on its recent acquisition of LinkedIn (LNKD) for future growth. The massive, $26 billion acquisition of LinkedIn, a workplace social media platform, provides Microsoft with growth in professional networking.

The deal creates, in Microsoft’s assessment, a more than $300 billion addressable market.

msft-linkedin

Source: LinkedIn acquisition presentation, page 9

Microsoft should expand its scale with LinkedIn’s 430 million users.

Competitive Advantages & Recession Performance

Microsoft’s main competitive advantage is its intellectual property. This is typically the case for large technology companies. Since the technology landscape changes so quickly, it is critical for tech firms to continue innovating new products and services.

In order to support its intellectual property, Microsoft spends heavily on research and development:

Such a huge amount of R&D spending is possible because of Microsoft’s tremendous financial resources. It has $137 billion of cash, marketable securities, and short-term investments on the balance sheet.

Microsoft is one of only two U.S. companies to hold the ‘AAA’ credit rating from Standard & Poor’s, along with Automatic Data Processing (ADP).

Its balance sheet strength is a competitive advantage which allows the company to invest more than $10 billion each year into R&D.

The company has a DIVCON safety score of 4 out of 5, signifying that it’s very unlikely the company reduces its dividend.

Another competitive advantage for Microsoft is its strong brand. According to Forbes, Microsoft has the third-most valuable brand in the world. The Microsoft brand is reportedly worth $75.2 billion.

You might assume that a technology company like Microsoft would be extremely vulnerable to a recession.

And while Microsoft did suffer an earnings-per-share decline in 2009, its growth rates in 2008 and 2010 more than made up for it.

Microsoft’s earnings-per-share through the Great Recession are shown below:

Final Thoughts

As mentioned previously, Microsoft’s valuation is its only downside. The stock has more than doubled over the past five years. It now trades for a price-to-earnings ratio of 29. This is above the S&P 500 average price-to-earnings ratio of 25.

And, Microsoft stock trades significantly above its own historical average. Since 2000, the stock has traded for an average price-to-earnings ratio of 18.

While Microsoft is an excellent company, it is not priced attractively at the present time. Future returns would be better if investors buy Microsoft at the market valuation or better. This would also help raise the dividend yield back to 3%, a more attractive level.

Dividend growth investors may want to wait for the next market downturn before buying the stock.


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