Tech stock dividends: Microsoft

One week ago I posted about tech stock dividends and that tech stocks may become great dividend stocks in the future. Well, its one week later, the Gators are playing again (this time vs Bama, god help us) and its time to revisit tech stock dividends again.

My conclusion in last week’s post was that it was too early to consider tech stocks as ‘good’ dividend payers, bar maybe Intel. The main reason is that tech dividend yields are among the lowest of any sector of the market and payout ratios are very low, both despite burgeoning cash balances and diminished (or less capital intensive) growth opportunities. Managements are coming around but returning cash to shareholders still does not seem to be among tech companies’ top priorities. Consider Microsoft.

I’ll just come right out and say it. Microsoft stock is cheap. Really cheap. I can’t find historical data going back far enough that tells me the last time it was this cheap. How cheap is it? Microsoft’s market cap is $211B as of yesterday’s close. It has $36B in cash and $6B is debt, call that $30B in net cash. It also generated $22B in free cash flow last year. That’s $22B after wasting money on stuff like Bing and even some productive stuff like Windows and Office. Add the numbers and figure how long it would take for Microsoft to buy itself. ($211B – $30B net cash)/$22B, that’s about 8 years to buy back all the outstanding shares. There are few if any businesses in the market that generate 40%+ return on equity (that is not a typo) and trade at this kind of valuation. Any other valuation metric also says the stock is cheap.

The problem is that Microsoft stock used to be really expensive, it used to be a high growth company, and in the past 10 years it has transitioned into a more stable lower growth company at cheaper valuations. And it has a bit of an image problem. Everyone loves Apple these days and hates Microsoft. A lot of people are certain Microsoft is going out of business – its just a matter of time. Maybe they are. I don’t really care. But right now the stock is priced for even worse than that. There are great businesses that are bad stocks and bad businesses that are great stocks. If you’re looking for a value stock that’s 30-40% undervalued and you’re willing to wait until the market comes around and realizes this then Microsoft is a great buy for capital appreciation and you get a decent dividend while you wait.

But I’m NOT going out and buying Microsoft stock by the boat load. I invest in quality dividend stocks in a certain target zone and Microsoft is not quite there. It just raised its dividend to $0.16 per share from $0.13, a nice bump. It has doubled its dividend in the last 6 years, that’s a 12% growth rate over this time. At yesterday’s closing price, its forward dividend yield is 2.6%. Potentially you’re looking at a stock that will generate 14.6% (2.6% + 12%) returns going forward if/when the market agrees. Not bad.

But if the market does not agree and the stock price stays flat for another say 10 years then you’re looking at returns of 4.55% per year. Ideally I don’t want to invest in stocks that are dependent on the market realizing their value to generate my target returns. What would change my mind? A higher stock yield, around 4%, would definitely do it. Microsoft has the ability to pay such a dividend and still maintain good dividend growth. Maybe management will come around soon.

P.S. There are other ways to generate income off these kinds of stocks. I would also include Intel in this bucket although its closer to quality dividend stock territory than Microsoft (although the McAfee acquisition really irked me). In a later post I’ll discuss an advanced income generating strategy that involves options that is great to use for stocks like this.