Microsoft: This Old Tech Company Becoming A New One – Seeking Alpha
Microsoft (MSFT) is one of the oldest and newest tech companies at the same time. While it benefits from a strong core business model generating cash flow, management has proven its ability to develop other growth vectors. Their most recent success is called Azure, which is No. 2 in public cloud services. Azure has doubled its sales over the past 12 months and is prone for several years of growth. Finally, its strong relationship with corporate America will open the door for additional cross-selling opportunities as the cloud business expands. Microsoft is a buy today, even if the PE ratio is over 27.
Understanding the Business
Founded in 1975 on the promise of offering the best computer operating system with a graphical user interface, Microsoft is now doing business in 190 countries. Its domination in the world of personal computing interface has even earned MSFT a few legal suits for being a monopoly.
However, MSFT has evolved greatly since then and we no longer wait for the next Windows update to see its sales burst. The company now shows a more diverse and balanced business model:
Author’s chart, source 2017 Q3 presentation
The “More Personal Computing” includes Windows, Surface, and their gaming division. While the world of personal computing is mature, MSFT has found two growth vectors with their tablets (Surface) and games (Xbox).
The “Productivity and Business Process” includes the Office suites, Dynamics products, and cloud services along with their latest important acquisition: LinkedIn. I like what MSFT has done with their Office suites over the years as they offer it under a subscription based program.
Finally, the “Intelligent Cloud” segment includes server products and cloud services (led by the fast-growing Azure) and enterprise services. This is the fastest growing part of MSFT business.
Microsoft’s revenue trend is quite impressive from 2008 to 2015, but we can see an important dip in 2016. In fact, this drop in revenue is due to adjustment management made on revenue deferrals from Windows 10 as stated in the 2016 annual report:
“Fiscal year 2016 compared with fiscal year 2015.
Corporate and Other revenue decreased $6.9 billion, primarily due to the impact of the net revenue deferral from Windows 10. During fiscal year 2016, we deferred net revenue from Windows 10 of $6.6 billion. During fiscal year 2015, we recognized a net $303 million of previously deferred revenue related to Bundled Offerings.
Corporate and Other operating loss decreased $2.0 billion, primarily due to an $8.9 billion reduction in impairment, integration, and restructuring expenses, driven by prior year goodwill and asset impairment charges related to our phone business, offset in part by lower revenue.”
If you want to look at how much cash MSFT generates from its sales, you get a better picture by looking at their cash flow from operations:
I like this graph better as it clearly shows MSFT’s ability to generate more cash from its business. As a dividend growth investor, this is a key component.
EPS dropped in 2016 due to a $7.5 billion goodwill impairment related to their phone fiasco (note). Then, MSFT showed another dip in 2013 for another goodwill impairment ( see note in 2013 annual report).
You can see there is a price to pay when you search for diversification outside of your core business model. While MSFT hit a homerun with the cloud business, their batting average is not 1,000.
Microsoft has a solid core business generating billions in cash flow. In order to make sure they continue to be a leader in their industry, massive investments and acquisitions are required. Overall, MSFT shows a strong earning trend.
Dividend Growth Perspective
Microsoft has successfully increased its dividend payment for 13 consecutive years, making the company part of the Dividend Achievers. The Dividend Achievers Index refers to all public companies that have successfully increased their dividend payments for at least 10 consecutive years. At the time of writing of this article, there were 265 companies that achieved this milestone. You can get the complete list of Dividend Achievers with comprehensive metrics here.
MSFT’s yield used to be more attractive a couple years ago when it was near 3%. Since then, even a double-digit dividend growth rate wasn’t enough to compensate from the stock price surge of 58% since January 2015.
Assuming management will announce a dividend increase for the last quarter of the year (as they usually do), it will have more than doubled their dividend payment since 2012 (from $0.20 to $0.39 before the 2017 increase). Even considering such strong dividend growth, both payouts and cash payout ratio remain well under control at 55.86% and 37.75% respectively.
Microsoft shows a few darker clouds over their head. The first one is obviously Windows desktop OS. Desktops are often replaced by smartphones, tablets, or 2-in-1 where Windows isn’t a major player. Desktops won’t disappear anytime soon, but there won’t be much growth to expect from them.
While MSFT found a strong growth vector in the cloud business and Azure as rapidly become the No. 2 player in the public cloud space services, the company isn’t alone in this market. First, Amazon (AMZN) continues to be dominant in this market while other giants like IBM (IBM) and Alphabet (GOOG) (NASDAQ:GOOGL) are not too far behind.
Competing with such giants will not be an easy walk in the park and it could hurt their margins at one point.
The last step of this analysis is to take a look at Microsoft’s valuation and determine if there is a buying opportunity here. Let’s first take a look at how the market values MSFT over the past 10 years.
It’s obvious there’s big excitement around the cloud business, especially when Azure almost doubled their revenues in Q3 2017. Still, a PE of 27.48 seems high in my opinion.
As a dividend growth investor, I’d rather use the dividend discount model (DDM) to determine the present value of future dividend payments. I decided to use a discount rate of 10% since MSFT environment evolves quickly. Who would have thought in 2000 that people would prefer to surf the Internet with their phone and tablet rather than using their “old” computer?
Source: How to use the Dividend Discount Model
At the time of writing this article (July 26), the stock was trading slightly higher than its fair value. Therefore, even with the hype around Azure, Microsoft is still a good buy at today’s price.
I think MSFT is a buy at this price mainly because there will be a 14th consecutive year with a dividend increase in 2017. Therefore, the DDM will have to be done again to consider this increase. I expect a dividend raise at $0.43 per share giving a DDM valuation at $78.55. There are lots of room for MSFT to grow both their business and their dividend in the upcoming decade.
Disclaimer: I do hold MSFT in my DividendStocksRock portfolios.
The opinions and the strategies of the author are not intended to ever be a recommendation to buy or sell a security. The strategy the author uses has worked for him and it is for you to decide if it could benefit your financial future. Please remember to do your own research and know your risk tolerance.
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