A new CEO has reinvigorated investor interest in Microsoft and could lead to a stronger growth strategy over the next several years. Even without a new strategy for growth, the company is a strong cash generator and has proven its commitment to return cash to shareholders. A strong balance sheet and the opportunity to take on more debt could drive a higher cash return even on moderate growth.
• Undervalued on a discounted cash flow basis with an extremely strong balance sheet and the potential to increase profits through leverage
• A new CEO that is re-examining growth and focusing on two segments where the company has a strong competitive advantage
• A commitment to returning cash to shareholders with $41 billion returned over the last three years
Satya Nadella took over as CEO from outgoing Steve Ballmer this year and is focusing to take advantage of the, “gold rush,” in cloud and SaaS markets which he believes Microsoft is one of just a couple of companies positioned to capitalize on the dual opportunities. Founder Bill Gates is spending about a third of his time with the new CEO and told CNBC that the software behemoth is, “re-examining all its strategies,” and rethinking how Microsoft can move faster.
Microsoft is opening up strong potential with its decision to offer Windows for free to OEMs making devices that are 9-inches or smaller. The decision could allow the company to take a decisive share of the mobile market which could save it from slower PC growth in the future.
As with many of the old guard tech companies like Intel (INTC) and Apple (AAPL), Microsoft has made the commitment to return cash to shareholders in the form of a dividend. The company has aggressively increased the dividend over almost a decade and will likely be a Dividend Aristocrat in the future.
Besides the company’s core products, the potential to surprise higher on additional products like Skype and server enterprise services could mean stronger gains in the future. Skype now accounts for a third of all international calls made globally and booked 40% growth in 2012, more than twice the combined volume growth made by all other phone companies in the world.
Despite all the calls of low growth, sales have increased by an annualized 7.5% over the last three years and 7.7% over the last decade. Cash on the balance sheet has ballooned to more than $88 billion in the last quarter against long-term debt of just $20 billion.
The company is financed with just 20.6% of its capital structure in debt and issues ten-year bonds at just 3.1%, a half percent above the treasury debt of the United States. With operating income topping $26 billion, Microsoft covers its interest expense by more than 62 times and could easily leverage up its returns by taking on more debt.
Free cash flow fell last year to $24.6 billion on a doubling of capital expenditures to $4.3 billion. The company has spent $5.9 billion over the last twelve months and the increased expenditures should come through with higher sales down the road. Even against the lower free cash flow, no one can deny that the company is a huge cash generator with FCF increasing at an annualized 6.2% over the last decade. Last year alone, the company created free cash of $2.90 per share or about 7% of the company’s market value.
Dividends and Growth
The shares’ current yield of 2.8% is slightly higher than the five-year average of 2.3% but largely a factor of lower growth opportunities in the PC market and increasing cash on the balance sheet. The company’s payout ratio of 38%, against a five-year average of 32%, is still low enough to leave room for capital spending on growth.
Dividends per share have increased by 16.4% on a five-year annualized basis though growth has exceeded 20% over the last three years. The company has paid a dividend since 2003 and has increased the payout per share for eight consecutive years.
Microsoft has clearly made the commitment to return cash to shareholders with nearly $41 billion returned over the last three years in dividends and share buybacks. The company paid out $7.4 billion in dividends last year and bought back $5.4 billion in shares. As balance sheet cash increases, Microsoft will likely need to increase its return of cash or face the same push by activist investors that has made Apple increase its dividend.
Shares trade at 14.9 times trailing earnings, slightly above the five-year average of 13.4 times but well below the industry average of 16.6 times earnings. The company’s price to book value of 3.7 times is under the five-year average of 4.2 times so price multiples do not seem to say that shares are necessarily expensive or cheap.
The shares may be slightly undervalued on a discounted cash flow basis with a fair value of $45.11 per share. With cash building up on the balance sheet and the company significantly under-leveraged, a dividend growth rate of 15% over the near-term should be more than sustainable. An estimated dividend growth rate of 10% over the longer-term and a terminal growth rate of 3.5% are also likely conservative.