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Expansion Into Cloud Services Breaks Microsoft Away From the PC
Microsoft Corporation (MSFT ) is one of the top-performing technology stocks over the past year. The stock has performed extremely well – shares have returned 33% just in the past one year, not including dividends – and has soundly beaten the S&P 500 in the same time. Its massive outperformance is thanks to the strategic shift Microsoft has made in recent years, which was to turn away from the personal computer and move toward cloud computing.
Due to its strategic refocusing, Microsoft has continued to grow and generate billions of dollars in free cash flow each year. With its pristine balance sheet and excellent cash flow, the company is able to return increasing levels of cash returns to investors, through both strong dividend increases and share buybacks.
On Sep. 20, Microsoft simultaneously announced a dividend increase and a massive share repurchase. The company raised its quarterly dividend by 8% to $0.39 per share, payable Dec. 8, to shareholders of record on Nov. 17. In addition, Microsoft announced a $40-billion share buyback to replace the existing $40 billion buyback authorization set to be completed by the end of 2016. The forward annualized dividend payout rises to $1.56 per share, which represents a 2.7% dividend yield.
Microsoft’s key strategic imperative over the past few years has been to invest and grow its cloud-based products and services, primarily Office 365 and Azure. This investment was made to protect the company against the decline of the PC. Indeed, this was the right decision, because the PC is facing a structural decline. For example, technology-market-tracking firm IDC calculated that worldwide PC shipments totaled 62.4 million units in the second quarter this year, which amounted to a year-over-year decline of approximately 5%, and IDC does not expect PC shipments to return to growth until 2018.
The reason for this trend is that consumers, at both the consumer and enterprise levels, are performing an increasing amount of computing functions on smartphones and tablets. This is a significant factor for Microsoft, because its legacy Windows operating system and Office Suite of software products are highly reliant on the PC; although the good news is that the company is not as reliant on the PC as it used to be.
Microsoft has prepared for the shift toward the cloud by investing in this new technology under the leadership of CEO Satya Nadella, and the results speak for themselves.
Last fiscal year, Microsoft’s constant-currency revenue totaled $92 billion, which excludes the negative impacts of the strong U.S. dollar. While revenue fell 2% year-over-year, Microsoft still saw excellent growth across its cloud platforms. It is rapidly replacing its former PC-based businesses with cloud businesses. Commercial cloud revenue reached a $12 billion annualized level last year. In the most recent quarter, Office 365 commercial revenue soared 59% on an organic basis, meaning normalizing for currency fluctuations. Azure revenue increased more than 100% last quarter.
Separately, Microsoft has seen very good performance throughout its other products lineup. One area of success is in tablets, where revenue grew 9% last quarter, thanks to strong sales of the Surface Pro 4 and Surface Book tablets. In addition, Microsoft’s Xbox One gaming console was a smash hit with gamers, as Xbox Live subscriptions soared 33% last quarter. Because of this broad-based success, Microsoft’s adjusted earnings per share increased 6% in the most recent fiscal year.
On a cash flow basis, Microsoft is a cash machine. Last year the company raked in $25 billion of free cash flow, a 5% annual growth rate. Such strong cash flow allows the company to maintain an excellent balance sheet and raise its dividend at high rates. Over the past several years, Microsoft has been a premier dividend growth company, growing its dividend by 80% over the previous five-year time span.
With huge levels of free cash flow and modest debt to service, Microsoft’s cash is piling up. The company has $113 billion in cash and cash equivalents, and it has a ‘AAA’ credit rating. Going forward, these are margins of safety that will allow for strong dividend growth each year. For example, even including Microsoft’s 8% dividend raise, the company’s dividend payout ratio is 50% of its annual free cash flow.
A payout ratio of half of free cash flow provides enough room for future payout increases, in the high-single-digit to low-double-digit range.
Technology stocks with high dividend yields are hard to find. The technology sector has not historically been a good source of dividends, but that is all changing and Microsoft is leading the charge. With its free cash flow, iron-clad balance sheet and growth in new business areas, the company has demonstrated a commitment to rewarding investors with an above-average current dividend yield and high dividend growth each year. As a result, Microsoft is a worthy addition to any dividend portfolio.