Microsoft Might Be The Best Technology Dividend Play

In the digital age, major enterprises are adopting digital processes to change the way they conduct business. An increasing number of enterprises are using digital technologies for not only engaging with their customers but also for empowering their employees and optimizing their business operations. As a part of their digital transformation strategy, enterprises are moving their IT infrastructure and business applications to the ‘cloud’, a popular term that refers to the internet and other remote computing resources. One of the key drivers in moving to cloud is to gain greater business insights by making use of Artificial Intelligence (AI), Big Data, IoT (Internet of Things) and Machine Learning. These emerging technologies when used in conjunction with cloud computing technology provide enormous capabilities that can help businesses to identify patterns and make accurate decisions. It has been forecasted that 28% of key enterprise IT spending will shift to the cloud by 2022.

Source: Gartner September 2018

To lead this new era of digital transformation, Microsoft (MSFT) is pushing out the boundaries of its core business to help individuals and organizations realize their full potential in the digital economy.  Best known for its Windows line of operating systems, MSFT has earned the reputation for being one of the leading cloud computing companies. The company provides a range of cloud services that can support an organization’s digital transformation. Microsoft Azure, MSFT’s cloud computing platform, is now one of the top 3 largest public cloud platforms, and it is continuously expanding to encompass new technologies. In recent years, MSFT’s cloud business has grown considerably and it is directly competing with players like Amazon (AMZN) and Google (GOOG) to dominate the cloud market.

Source: Rightscale2018 State of the Cloud Report

Besides providing cloud services, MSFT is also incorporating artificial intelligence and machine learning in its cloud platform to enable the development of intelligent apps. MSFT’s key competitive advantage lies in modernizing applications with AI. It has already reorganized its business to better focus on its fast-growing cloud-computing segment. The reorganization has enabled the company to reposition itself as a cloud-focused organization which sells operating systems, devices and business productivity software.

Organizational Realignment

As a part of the reorganization, MSFT has realigned its engineering teams around three segments:‘Intelligent Cloud’, ‘Productivity and Business Processes’, and ‘More Personal Computing’. The company’s ‘Intelligent Cloud’ segment consists of server products, cloud services and enterprise services that can power modern businesses. The segments server products and cloud services encompass on-premises as well as cloud-based operating systems, databases, software development tools and cloud platform services. The segments enterprise services comprises support services and consulting services.

Source: CBInsights.com

The ‘Productivity and Business Processes’ segment consists of applications and services that improve business productivity and facilitate communication services across a variety of devices and operating platforms. These products and services include on-premises as well as cloud-based business applications that hone productivity. Additionally, MSFT’s productivity products also include LinkedIn talent solutions, marketing solutions and subscription services.

Further, MSFT’s ‘More Personal Computing’ segment encompasses Windows operating system, devices (including laptops, tablets, desktops, phones and 2-in-1s), Bing search engine and gaming hardware and software services. By focusing on its three segments, MSFT ensures that it can sell unique product and service offerings to a broad range of customer segments.  Moreover, MSFT is diversifying into new markets to avail growth opportunities outside of its traditional business. Emerging growth areas like gaming and educational technologies have driven the multinational company to shift its focus from PC software to other areas with higher growth potential. The company’s strategy to diversify and tapping new growth markets is primarily driven by acquisitions.

New Growth Opportunities

Since 1987, MSFT has been acquiring software companies that possessed complementary strengths and which helped the tech giant to expand its product portfolio. However, MSFT has now focused on acquiring those companies from unrelated sectors which are now being considered as high-growth markets. The company has lately been acquiring a number of smaller companies from a diverse set of emerging sub-markets that include cloud gaming, employee engagement software, education technology, artificial intelligence and collaboration platforms. By diversifying into these growing markets, MSFT expects to gain an edge over its competitors like Alphabet, Amazon and Apple. MSFT’s competitors are already eyeing the emerging markets and hence acquisition is one of the best ways that will help MSFT gain a leg up against the competition. An effective implementation of MSFT’s strategy was seen in the previous quarter when the company acquired Flipgrid, a video-based educational platform, which is being used by more than 20 million students and teachers across the world. By acquiring Flipgrid, MSFT has positioned itself as a worthy competitor to Google which is already marketing its cloud-based products and Chromebooks to educators.

In Q2 FY19, MSFT grew its first-party game developer base by acquiring game studios. Obsidian and InXile.  MSFT’s acquisition strategy is in line with its goal to become a leading first party game developer. The company realizes that the demand for cloud gaming will continue to grow due to increasing proliferation of smart devices and high-speed internet. In the previous year, the company had acquired four game studios and had also set up a new studio. The second quarter resulted in the largest gaming revenue quarter for MSFT and the revenue growth was driven by record user engagement and record average revenue per user. As of this writing, MSFT owns 13 game studios and it is expected that the company will continue to acquire more studios to catch up with Sony and Nintendo.

In the second quarter, MSFT acquired Glint, an employee engagement platform, and the software will now be a part of other MSFT employee engagement applications that include LinkedIn Talent Solutions, Talent Insights and LinkedIn Learning. MSFT’s acquisition of Glint comes at a time when there is a growing demand to attract, retain and develop the best talent in a highly competitive jobs marketplace. With regard to LinkedIn, MSFT continued to generate strong revenue growth in the second quarter with sessions growing by 30% year over year. The growth was driven by record levels of engagement in the feed and content shared across the LinkedIn platform.

Further, MSFT has closed the acquisition of GitHub, a collaborative software development platform, in the second quarter. GitHub has proved to be an extremely popular collaborative platform and more than 31 million developers use it to collaborate in real-time. Moreover, development teams at more than half of the Fortune 50 use the enterprise version of GitHub. MSFT has plans to significantly update the platform to make it accessible to even more developers. The demand for collaborative tools like GitHub is being primarily fuelled by three drivers, namely an increasing number of millennials in the workforce, the growing use of cloud computing devices and rising use of social network within organizations.

In the second quarter, MSFT further penetrated the AI market by acquiring XOXCO, an AI and bot development house. In previous quarters, MSFT had acquired AI development companies Bonsai and Lobe to seamlessly develop and deliver AI solutions. In future, the emerging AI market will offer MSFT ample growth opportunities due to an increasing adoption of cloud-based solutions, an increasing demand for intelligent virtual assistants and the growth of big data. FSLogix and Citus Data were the other companies that were acquired by MSFT in the second quarter. FSLogix is a desktop app management software and Citus Data is a database for cloud computing.

Penetrating Existing Markets

Besides targeting new markets, MSFT has also achieved considerable penetration in its existing markets due to strong growth in Q2 of FY19. This growth was primarily driven by the excellent performance of MSFT services like Azure, Office 365 business services, Dynamics 365 and its Enterprise Mobility and Security Suite (EMS). Collectively known as ‘commercial cloud’, these services were the chief contributors of the revenue growth in the second quarter.

The quarter’s most notable growth came from Dynamics 365, the company’s cloud-based ERP (Enterprise Resource Planning) system. Dynamics 365 achieved a year-over-year growth of 51% as the company won customers by making the system more modular and more AI-driven. MSFT’s growth in the second quarter is also attributable to the company’s Surface family of devices. In the quarter, MSFT’s Surface delivered a strong double-digit growth as it came to a peak. MSFT continues to extend the Surface product line by adding innovative features to existing product models.

In the second quarter, MSFT accelerated innovation in products that included cloud platforms Azure IoT and Azure AI as well as Microsoft Teams collaboration software. With regard to Teams, MSFT has introduced enhanced voice capabilities like group call forwarding, location-based routing and delegation. The second quarter also saw the rapid adoption of Teams among enterprise customers. As of now, more than 420,000 organizations and 89 of the Fortune 100 companies are using the collaboration tool for messaging, meetings, video conferencing and document collaboration. In the quarter, MSFT also introduced advanced capabilities to its products for enhancing cybersecurity and threat protection. MSFT has adopted a comprehensive approach to security and compliance that will help enterprises to comply with government regulations concerning data privacy and data protection.

On the gaming front, the number of active users for Xbox Live, the online multi-player gaming platform, reached a record 64 million in the second quarter. The number of customers engaging in Mixer, the live streaming platform for gamers, and the number of customers subscribing to Xbox Game Pass, a subscription service, also reached all-time highs. Minecraft, a popular Microsoft-owned gaming franchise, delivered record revenue in the second quarter as its gaming product expanded across new platforms, geographies and customer segments like education. Another record was achieved by Playfab, the cloud-based gaming platform, in the second quarter when the number of player accounts on the platform exceeded the 1 billion mark.

Financials and Guidance

At the end of FY19 Q2, MSFT reported revenue of $32.5 billion and an operating income of $10.3 billion. The company’s net income was $8.4 billion GAAP and $8.6 billion non-GAAP. For the fourth quarter, MSFT’s figures for diluted earnings per share were $1.08 GAAP and $1.10 non-GAAP.

Source: Microsoft FY19 Q2 10Q document

This quarter, MSFT’s revenue grew by 13% in constant currency and its operating income increased by 18%. The growth was primarily due to MSFT’s Commercial Cloud services that led to a year-over-year revenue growth of 48% at the end of December 2018.

Source: Microsoft FY19 Q2 10Q document

The gross margin percentage of commercial cloud increased to 5 points from a year ago to 62%. The growth was driven by significant improvement in Azure gross margins. In the second quarter, MSFT’s operating expenses increased by 26% due to a continuous investment in cloud, AI engineering, commercial sales capacity and GitHub.

Source: Microsoft FY19 Q2 10Q document

In terms of segments, MSFT’s ‘More Personal Computing’ segment contributed the most towards FY19 Q2 revenue. MSFT’s second quarter revenue for this segment was $13 billion which is 7% growth in constant currency as compared to the same quarter of previous financial year.  Windows OEM (original equipment manufacturer) revenue declined by 5% in constant currency while the Windows Commercial products and cloud services increased by 14% in constant currency. The revenue for the company’s Windows OEM business was lower than expected due to the constrained chip supplies to its OEM partners.  In Q2 2019, the company’s Surface computers and devices increased by 41% in constant currency and the gaming revenue was up 9% in constant currency. Moreover, MSFT’s search advertising revenue excluding traffic acquisition costs increased by 14% in constant currency.Within the gaming sub-category, Xbox software and services contributed a revenue growth of 32% in constant currency. The growth was primarily driven by continued strength from third-party game publishers. Additionally, strong subscriber growth across MSFT’s gaming subscription services like Xbox Live and Game Pass has helped to compensate for the lower-than-expected performance from other third-party video games on the platform.

Source: Microsoft Second Quarter Fiscal Year 2019 Results

For FY 19 Q2, MSFT’s Productivity and Business Processes segment reported a revenue of $10.1 billion and it achieved a year-over-year growth of 13%.This growth was primarily driven by driven by Office 365 commercial, LinkedIn and Dynamics 365.Within the segment, Office Commercial products and cloud services revenue increased 11% in constant currency and the growth was driven by Office 365 Commercial revenue growth of 33% in constant currency. Additionally, Office Consumer products and cloud services revenue increased by 2% in constant currency with growth in Office 365 Consumer subscribers to 33.3 million. Further, LinkedIn revenue increased by 30% in constant currency with record levels of engagement. Dynamics products and cloud services revenue increased by 17% in constant currency and the growth was driven by Dynamics 365 revenue growth of 50% in constant currency.

Source: Microsoft Second Quarter Fiscal Year 2019 Results

MSFT’s FY 19 Q2 revenue for the Intelligent Cloud segment was $9.4 billion and it is up by 24% in constant currency as compared to the same period of last year. Within the Intelligent Cloud segment, the revenue due to server products and cloud services increased by 24% in constant currency and the growth was caused by Azure revenue growth of 76% in constant currency.  Additionally, the revenue of the ‘Enterprise Services’ sub-segment increased by 7% in constant currency.

Source: Microsoft Second Quarter Fiscal Year 2019 Results

In the second quarter, MSFT returned $9.6 billion to shareholders through share repurchases and dividends. The company’s Q2 share repurchase is reportedly $6.1 billion higher than its normal quarterly pace. Additionally, the share repurchase is meant to fully compensate for the stock consideration that was issued during GitHub acquisition.

For the rest of FY 2019, MSFT will continue to make strategic investments for capturing expanding market opportunities and for driving growth across its business segments. In FY19 Q3, MSFT expects a decrease to its total revenue growth of 2% due to the impact of foreign currency exchange rate movements. The revenue growth will decrease by 2% in Productivity and Business process segment which is expected to generate revenue of $9.90 to $10.10 billion. The Intelligent Cloud segment’s revenue growth will decrease by 2% and it will generate revenue of $ 9.15 to $ 9.35 billion for the third quarter. Further, the More Personal Computing segment’s revenue growth will decrease by 1% and the segment will generate revenue of $10.35 to $10.55 billion. Windows OEM revenue growth will continue to be in the low single digits due to the market impact from constrained chip supply in the third quarter. The increasing demand for Surface computers and devices is expected to drive another strong quarter of over 20% growth, however, and MSFT’s revenue growth for gaming will be slightly higher than the last quarter and the company’s search revenue ex-TAC (traffic acquisition cost) is expected to be similar to Q2.

Additionally, the company’s full year total expenses are expected to grow roughly 8%. The company projects that its full-year operating margin will grow slightly year over year. The operating margin will also include the full GAAP impact of GitHub. Due to the presence of significant growth opportunities, MSFT will continue to invest in strategic growth areas like Azure, AI, GitHub, Dynamics, LinkedIn, Teams, gaming content and the Power business application platform.

The Best Technology Dividend Play

When investors think of investing in Technology stocks they likely are looking at the potential for price appreciation and capital gains, not necessarily the income potential. However, MSFT is a very mature Tech company even if it is delving into disruptive new areas. As a more mature, larger cap company, it has been paying dividends for quite some time and although the dividend yield is not comparable to those found in real estate, utilities, or consumer staples, it has grown by 13% over the last 5 years and 14% annualized over the last 10 years. Most of that growth has come in the last 5 years when the dividend doubled from $0.89 in 2013 to $1.65 in 2018. It is also forecast to increase to $1.82 in 2019, another 10% increase.

Source: The Income Strategist Calculations

There is a caveat however, and that is, the company looks a bit pricey at a Price/FCF of 27 and PE of 30. The trailing 12 month EPS was $4.31 and FY estimates are for earnings per share of $4.98. At a PE of 30, that would put the price at roughly $150 but the multiple may be a bit stretched at the moment. Despite an overwhelming Buy rating, the analyst price targets are only 6% above current levels. We see that as a result of an inflated multiple.

The play here in our opinion is a dividend growth target of 10%, with any price appreciation as icing on the cake. With a payout ratio of 76% – the second highest payout ratio for the company – we still see plenty of room for dividend boosts. Add to that the possibility of buybacks, which have yielded 1.6% recently, and you have a potential yield of over 3% upside risks to both the dividends and the share price.

We rate the stock a Buy and are adding it to the Technology Income List as well as the Dividend Growth portfolio – both of which we are in the process of building out.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is meant to identify an idea for further research and analysis and should not be taken as a recommendation to invest. It does not provide individualized advice or recommendations for any specific reader. Also note that we may not cover all relevant risks related to the ideas presented in this article. Readers should conduct their own due diligence and carefully consider their own investment objectives, risk tolerance, time horizon, tax situation, liquidity needs, and concentration levels, or contact their advisor to determine if any ideas presented here are appropriate for their unique circumstances.