Saturday, May 2, 2015

Recent Purchase - Microsoft (MSFT)

First off, I want to thank all of you readers out there that purchased my book – you guys made it the #1 best seller on Amazon right now for Kindle e-books in the Stock Market Investing category. Thank you so much!
With that said, let’s get into some stock talk. 
I was fortunately able to put some more capital to work one last time this month. This will for sure be my last stock purchase for April, but I had a little excess cash sitting around and I just didn’t like that. Lazy money is bad money. I want my money to work for me so I don’t have to. That way I can be the lazy one, if I so choose.
I don’t know if I’m feeling a bit more adventurous lately, but this is my second transaction this month in the tech sector. I’m personally not a big fan of the sector as a whole, but a couple things are happening here. First, my portfolio has grown significantly over the last few years while I’ve simultaneously almost completely avoided tech. Thus, the portfolio’s weighting there is perhaps light even for my tastes (my exposure is almost nonexistent). Second, I’ve come to realize over time that many of the high-quality, blue-chip tech companies are absolute cash cows.
My strategy with tech going forward is basically to keep my exposure light to the entire sector relative to my portfolio, diversify between a few small positions, focus on major blue-chip companies that sell ubiquitous products and/or services – the true cash cows of the industry (nothing nascent) – and make sure I understand as much as I can.
Keeping to that strategy, I initiated a position in one of the most well-known tech companies in the world.
I purchased 25 shares of Microsoft Corporation (MSFT) on 4/17/15 for $41.28 per share.

Overview

Microsoft Corporation develops, licenses, and sells a range of software and services; and designs, manufactures, and sells a variety of hardware.
Some of the company’s main products and services include Windows, Office, XBox, Azure, Bing, Surface, and Windows Phone.
Fiscal year 2014 revenue breaks down by the following five operating segments: Commercial Licensing, 48%; D&C (Devices & Consumer) Licensing, 22%; D&C Hardware, 13%; Commercial Other, 9%; and D&C Other, 8%.

Fundamentals

Microsoft is well-known, but thought of as perhaps a staid company representing old tech. However, their growth over the last ten years tells a far different story.
The company’s revenue increased from $39.788 billion in fiscal year 2005 to $86.833 billion in FY 2014. That’s a compound annual growth rate of 9.06%.
It gets better.
Earnings per share grew from $1.12 to $2.63 over this time frame, which is a CAGR of 9.95%.
So we can clearly see they’re not dying off. Now, some of that bottom-line growth was due to extensive share repurchases – the company bought back approximately 23% of the outstanding shares over the last 10 years. And they authorized a $40 billion share repurchase plan on September 30, 2013.
S&P Capital IQ is predicting that EPS will compound at a 9% annual rate over the next three years, which is nearly in line with what we see above.
The company’s clearly growing, but are they sharing that growth with shareholders in the form of a growing dividend?
Well, you can probably already guess the answer to that since I just bought shares.
They’ve increased the dividend for the past 12 consecutive years, which is a streak that started not long after former CEO, Bill Gates, stepped down.
Meanwhile, the rate at which the dividend is growing is even more impressive. The 10-year dividend growth rate is a stout 21.8%.
Some of that growth has come at the expense of a rising payout ratio (the dividend has grown about twice as fast as EPS over the last decade), but, at an even 50%, there’s still plenty of room for future dividend raises more or less in line with EPS growth.
The yield right now is 3%, which is obviously pretty attractive. That’s more than 100 basis points higher than the broader market, by the way. It’s also significantly higher than MSFT’s five-year average yield of 2.6%.
I often like to invest in companies with spectacular balance sheets, and MSFT, like recent stock purchase Apple Inc. (AAPL), doesn’t disappoint.
Microsoft is one of only three US companies with a AAA credit rating. Their long-term debt/equity ratio of0.23 and an interest coverage ratio of north of 47. They have more than $85 billion in cash on the balance sheet. Yes, $85 billion.
Also like AAPL, MSFT’s profitability is through the roof. Their net margin has averaged 27.93% over the last five years, while return on equity averaged 34.47% over that period. Really outstanding numbers here.

Qualitative Aspects

Microsoft has a number of competitive advantages, primarily in the strength of their Windows, Office suite, and server businesses.
I spoke of the strength of an ecosystem when discussing Apple recently, and Microsoft enjoys the same benefit. There’s a stickiness there to using Microsoft’s products, especially as it relates to software. Because their software is designed to work in unison and there’s a learning curve of sorts there, the odds of customers continuing to use their products are somewhat high.
Meanwhile, the enterprise side of the business remains particularly robust due to recurring licensing, switching costs, economies of scale, and their ability to provide multiple solutions. I was a bit concerned as to how the changes in technology in terms of stronger competition and the change to cloud would affect Microsoft and their primary product offerings, but they’ve done well.
What I can see when looking over their financial reports is that while the revenue that Windows generates has declined slightly over the last few years, they’ve more than made up for that with server and cloud revenue. So that indicates they’re not only able to retain clientele as the shift to cloud computing occurs, but they’re also able to scale up Azure fast enough to more than make up for any small losses on the OS side. Meanwhile, Windows has remained surprisingly resilient.
In addition, I love the company’s diversification across products and services. Office is still their largest product by revenue at 28% of the top line (FY 2014), but server products and tools made up approximately 20% of last fiscal year’s revenue. Meanwhile, Windows was just less than 20%. So while Windows is still about 1/5 of the business, the changes there aren’t affecting the company as drastically as one might initially think. And they’re not as reliant on Windows as it would first appear, either.
One really interesting aspect about Microsoft is that they’ve only had three CEOs. Satya Nadella was named CEO of the company in February 2014, taking over from Steve Ballmer. This is perhaps an important – and exciting – shift, as Nadella’s background includes server and cloud computing among his prior duties with his 20+ years with the company, previously heading up MSFT’s Azure business. This could mark a new era for Microsoft, as it continues to focus less on Windows and more on dynamic solutions involving cloud computing.
Lastly, I’ve long been concerned about changes in tech and how that affects some of the entrenched players. However, MSFT’s prodigious free cash flow generation puts them in a fortunate position where they can shift and adapt as they see fit, which gives them additional flexibility and potential growth opportunities on top of organic growth and any developments their internal research & development can provide (they spent $11.4 billion on R&D last fiscal year). For perspective, they generated more than $26 billion in FCF last year – that’s more than three times what PepsiCo, Inc. (PEP) generated their last FY.
If that’s not incredible enough, there’s that $85+ billion in cash on the balance sheet. Obviously, MSFT has to use that cash intelligently. But the flexibility adds value all in itself.

Risks

Like all businesses, MSFT faces risk.
Primarily, I see the company’s competition as a large risk. This competition is fierce across all of their product lines, which means MSFT has to continue developing attractive products and services to stay relevant.
Their track record in some of their product lines isn’t historically great, especially in the smartphone space. Their poor record at developing relatively successful mobile devices could make it difficult to add customers to their ecosystem.
Windows is still a large part of the business and is declining, which could threaten their economic moat by shrinking the customer base within their ecosystem and allowing competition to encroach on their competitive position.
The very nature of their industry is somewhat of a risk. Technology changes rather rapidly, and so they must use their resources carefully in order to maintain growth.
The company also faces acquisition risk, as paying too much for any acquisitions could lead to subpar returns.
Lastly, as a global company, there are currency risks to be concerned with.

Valuation

The stock’s P/E ratio is 16.65 right now. That compares awfully favorably to the broader market, but the five-year average P/E ratio for MSFT’s stock is only 13.5. Clearly, there were better deals available on this stock before, but I don’t necessarily think that indicates the stock is expensive right now. It’s just less cheap than it was before.
I valued shares using a dividend discount model analysis with a 10% discount rate and a 7% long-term dividend growth rate. That appears fair considering their long-term growth across the bottom line and the dividend. Though, the dividend is unlikely to grow much faster than EPS moving forward due to the payout ratio not being as low as it was at the start of the last 10-year period. Nonetheless, robust growth here remains. The DDM analysis gives me a fair value of $44.23.
I think there’s a modest discount to fair value available right now, which is somewhat rare in this market. Getting a high-quality stock with a margin of safety attached to it is always something I’m interested in, especially when I have capital available and space in the portfolio.

Conclusion

Microsoft, perhaps to the surprise of some, is actually adapting quite well to the changes across tech as it diversifies and strengthens its lineup across products and services. Though Windows is slowly shrinking, they’re more than making up for this across their other offerings, namely with server and Office suite products and services. Commercial Cloud is still a small part of Microsoft, but it’s growing rapidly – up 115% year-over-year.
There’s just a lot to like here. The company is growing at a rather strong rate and they’re sharing the wealth with shareholders in the form of an aggressively increasing dividend. Meanwhile, you’re paid 3% to own the shares. FCF not only covers the dividend handsomely, but cash alone could pay the dividend for almost a decade. They’re just incredibly flexible and well capitalized. I see no reason why the dividend won’t continue growing at a suitable rate for the foreseeable future.
This adds to my growing tech exposure, now sitting alongside my positions in AAPL and International Business Machines Corp. (IBM). Although, tech still only makes up a bit more than 2% of my whole portfolio. As I’ve mentioned before, I’d like tech to be somewhere around 2.5% over the long haul. So I’m not too far off now.
This purchase adds $31.00 to my annual dividend income, based on the current $0.31 quarterly dividend.
I’m going to include current valuation opinions from analysts, which I use to concentrate my reasonable valuation estimate:
Morningstar rates MSFT as a 3/5 star value, with a fair value estimate of $46.00.
S&P Capital IQ rates MSFT as a 3/5 star Hold, with a fair value calculation of $47.90.
I’ll update my Freedom Fund in early May to reflect this recent purchase.
Full Disclosure: Long MSFT, AAPL, PEP, and IBM.
What are your thoughts on MSFT? Like the stock? Surprised by the growth and margin? 
Thanks for reading.

This article was written by Dividend Mantra. If you enjoyed this article, please subscribe to my feed [RSS]

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