Core Business
Microsoft is a giant of the technology industry. The owner of the dominant Microsoft Windows and Microsoft Office franchises, Microsoft is a $225B company with more than $70B in annual revenue and 76% gross margins with net income of close to $17B.
The Microsoft Business Division (which is really the Microsoft Office franchise) actually accounts for most of Microsofts revenue (close to 35%). The Server & Tools Business and Microsoft Windows Business are fairly close in terms of revenue contribution at almost 25% each. The entertainment division (think XBOX) and online services division make up close to 15% revenue between them.
The Windows and Office franchises have been dominant for lengthy periods of time. Office has greater than 90% of market share in the enterprise productivity market, and frankly, it the really the anchor point for much of Microsoft’s other revenue streams.
Why is this the case? Much like with mobile devices, a operating system (whether it be Android or Apple’s iOS ) is only really as useful to someone as the things that you can do with that operating system (ie the mobile apps!).
In the case of Microsoft Windows, the things that you can do with Windows are the things you have with Microsoft Office (ie word processing, spreadsheeting etc).
So Microsoft Office really drives much of the Windows Business, as well as the Microsoft Server business in my view (there won’t be much of a need for an enterprise to have Windows Servers if there aren’t many machines running Microsoft Windows solutions, or Microsoft Office). So for the Microsoft growth case to remain strong, you have to believe that Microsoft Office will continue to remain a dominant franchise.
Where is the Growth?
PC sales flat – Microsoft Office is predominately deployed on PC’s and laptops. What is the forecast for PC’s? Barclays have forecast PC growth to decline some 2% over 2012 and some 4% in 2013. This is because there aren’t many compelling reasons to upgrade PC’s, and with tablets increasingly becoming computing devices of choice, its unlikely that there is a catalyst to reverse this decline in the years to come.
Smartphone & Tablet – Smartphone & Tablets are the computing devices that are experiencing rapid growth, at the expense of the PC market. How does Microsoft figure in the rankings? According to Commscore, Microsoft had only a 3.6% share of mobile devices as of September 2012. Microsoft also launched its own tablet offering, the Surface tablet. While its still early days for the Surface, analyst commentary suggests sales have thus far been fairly weak.
Microsoft Office Pricing – Pricing is one way that Microsoft could expect to shore up Office revenues. How is Office pricing expected to hold up?. Microsoft had a 20% price cut on their Office 365 product in early 2012. Trefis estimates that pricing for Microsoft Office Enterprise licenses will fall from $49 to almost $40 a license by 2018.
BYOD (Bring your own device)- There is an increasing trend of users to bring their own devices into the workplace. The IPAD kicked off this trend, and its only been accelerating since. Its unclear how these trends may impact Microsoft revenue, but I believe Microsoft charge based on a Client Access License (ie a Per User License). So if an individual is bringing in an additional laptop and hooking up an enterprise instance of Microsoft Office, it isnt clear to me that Microsoft are making additional revenue, as its still just one user.
Google Apps & Quick Office – The last few years have seen an emergence of competitors to Microsoft Office including Google Apps & Quick Office (Google recently bought Quick Office to strengthen the Google Apps franchise). While these products are helping disrupt Microsoft’s hold on the SMB and smaller enterprise market at the very least, will keep a cap on Microsoft Office pricing even if they don’t lead to a loss of Microsoft share (though I expect Microsoft will see some small share declines over time)
My thesis on the Microsoft business is that it has a dominant franchise in the enterprise productivity market. However in my view, its future growth prospects look less clear. The PC market will experience moderate declines, Microsoft has yet to capture any revenue share of substance in the Mobile market, and prices for Microsoft Office CAL’s appear to be on the decline. As I indicated above, my belief is that Office drives much of the Microsoft Business revenue, probably indirectly as much as 60-70% of it.
As a dividend growth investor, I want to be able to see the some signs of operating income growth, cashflow growth and therefore dividend growth for years to come.
What do the numbers say?
10yr /5yr revenue
Microsoft compound revenue growth over the 10 year period (2003-2012) has been a very acceptable 10% p.a .
Both “halves” have been roughly equal. 2002-2007 revenue growth was a good 12% p.a while 2007 to 2012 has been a more modest 8% pa, slower but still reasonable for a company its size
10 yr / 5 year operating cash flow growth
Microsoft operating cashflow over the period has also been a modest 8% p.a. 2003-2007 cashflow growth was a meagre 3% p.a for the period, while 2007-2012 has been 12% p.a, more what you would expect given the revenue growth and high gross margins its been generating.
Dividend Growth Rates
During the 2003-2012 period, Microsoft has had an impressive dividend growth rate which has averaged an impressive 28% p.a . And in the last 5 years? Microsoft’s dividend from 2007 to 2012 has increased 14% p.a over this period, roughly in line with operating cash flow growth.
A review of the payout ratio in recent years suggest a slight uptick, though at around 40% this is not of any great concern, and shouldn’t be of alarm.
Wrap Up
Microsoft is a solid business, built on the back of dominant positions in Windows and Office. Revenue growth is still very respectable, at close to 10% p.a over an extended period of time, with good operating cashflow generation. Dividends have also been increased strongly, consistent with operating cashflow generation. The numbers and historical performance for Microsoft go quite a distance to putting to rest any suggestions that it can’t continue to grow revenues, dividends and cashflow strongly.
As a dividend growth investor, I need to be looking out into the future, and while I believe Microsoft can comfortably maintain its dividend, my thesis suggests that it will start running into growth headwinds in the near to medium term, which may impact its ability to deliver consistent dividend growth increases.
To that end, I’m comfortable staying out of this stock.
I suspect that Microsoft will eventually be a mature dividend growth company. Almost everyone who uses a computer has a Microsoft product. The Windows operating system will be the predominant OS for a while. I don’t see Apple or Linux making serious inroads. I’m not worried about the dominance of Office either. Google is too busy trying to win in the worlds of mobile computing and social networking to put the necessary resources into making their Office suite competitive.
And as the economy slowly improves we should see more businesses upgrading their PCs, operating systems, and office suites.
The one worrying thing about Microsoft is that it was really late to the world of mobile computing. I’m not sure if a Windows phone has a chance. Maybe in the long term, but not the short term. Especially since Microsoft’s partner is Nokia, which has basically been crushed out of the industry.
Hi My FI,
Thanks for swinging by and for the well considered response.
Having gone through and done the analysis, I actually think that Microsoft’s current position (at least growth wise) is much better than I had given them credit for. Revenue growth is still good, and they remain a cash generating machine, so any decline in the core PC revenues isn’t apparent at this stage.
I do agree that any decline in the core PC Windows & Office revenues will take years to play out. It’s likely more a 5 year type timeframe where the declines will occur, but I do think that they will eventually happen.
Its then a question of whether Microsoft can make a successful transition to have a presence in the smart phone/ Tablet space. Frankly, I’m surprised they haven’t done a better job at this. The wireless carriers desperately want a viable No 3. The last think they want is Google & Apple dominated ecosystem, so they are happy to additionally subsidize Microsoft devices to help them get share.
The main problem is that Microsoft has no love from consumers. I don’t think that can change over night, especially since they were so late to the smartphone game. And some of their recent smartphone efforts , Microsoft Kin for example, have been terrible failures.
This needs to be addressed if Microsoft wants to make up the inevitable declines that will happen (in my opinion) in its core PC windows/office business.
If I were already in Microsoft stock, I would probably be content holding it for the moment as these forces will take years to fully play out. And who knows, by then Microsoft may well have rediscovered its mojo in the smartphone and tablet space.
Integrator
Thanks for this informative analysis. While I agree that there is uncertainty regarding Microsoft’s growth prospects, everything I’ve read makes me cautiously optimistic that the company will do okay. If they can make better progress in mobile computing, then their future will be brighter.
As you know, I started a small position in MSFT this past week, and my plan going forward is to monitor their operating results to see whether dividend growth is likely to continue. Even though I consider tech stocks to be riskier than stocks in other sectors (e.g., consumer staples), I think my capital risk with MSFT is somewhat reduced by having a decent margin of safety, which I calculated at around 25%.
Thanks for stopping by DGM.
I believe Microsoft certainly have time on their side to work through the mobile computing challenge to be in a position to see sustained growth into the future. Some of the macro themes I outline will take years to play out. In the mean time, what you do have is still a solid franchise on a PC platform, which while not accelerating, isn’t in any great danger of being upturned in the near term. So solid growth and good cashflow will keep the dividend safe and continue the growth in the short to medium term.
Solving the mobile computing platform problem they currently have can help give them that next leg of growth which should additionally power future dividend increases in the medium to long term.
Integrator