Microsoft: One of the Best Dividend Growth Stocks in Tech

Founded in 1975, Microsoft (MSFT) is most famous for its Windows operating system, which runs approximately 75% of the world’s computers.

However, in recent decades the company has vastly diversified its operations to become a software and hardware powerhouse that operates three distinct business segments:

While personal computing remains the firm's largest revenue driver, these legacy businesses are by far the slowest growing. Microsoft's fastest-growing and most profitable businesses are focused on cloud computing as well as subscription-based Office and enterprise products.

For example, commercial cloud revenue (Microsoft Office 365 commercial, Microsoft Azure, Microsoft Dynamics 365, and other cloud properties) grew 56% in fiscal 2018 to reach $23.2 billion, representing 21% of total company sales.

Microsoft has paid uninterrupted dividends for 13 consecutive years and raised its dividend for nine straight years.

Microsoft became an industry giant on the back of its Windows operating system (OS) and the rise of personal computers (PCs) in the 1990s. However, under former CEO Steve Ballmer, the company's ill-conceived notion of "Windows and PC first" led to years of stagnant growth.

PC demand slowed, driven by the rise of mobile devices, and rivals in both consumer (open source software and Google Docs) and enterprise (Linux-based enterprise solutions) markets began to erode its wide moat.

In 2014, Satya Nadella, a 20-year veteran of the company and head of its cloud computing division, took over as CEO with a "cloud and mobile first" vision to pivot the company into the fast-growing industries of tomorrow.

It hasn't been a perfect transition, as the failure of Windows 8 and the abandonment of the Windows Phone mobile operating system demonstrated. However, as a whole, Nadella's strategy of shifting Microsoft away from its traditional reliance on PC-installed Windows and enterprise server solutions has been a triumph.

The company is now laser-focused on subscription services, including Office 365 enterprise, Office 365 consumer, and Dynamics 365 (enterprise-level data analytics), all built around its Azure cloud computing platform.

In essence, Microsoft is no longer stubbornly clinging to its high margin but declining past, but focused on a fast-growing future filled with recurring, annuity-like revenue that offers even higher margins to boot.

Microsoft's success can be seen by the steady growth recorded in late 2018 across its most important offerings, including: 

In fact, thanks to the success of Azure, Microsoft is the world's second-largest cloud computing company, trailing only Amazon Web Services (AWS). More importantly, with nearly 100% annual growth the last two years, Microsoft's cloud business is gaining market share.

Research firm Gartner expects enterprise-level cloud to become increasingly concentrated in integrated Infrastructure as a Service (IaaS) and Platform as a Service (PaaS), cloud platforms like what Microsoft is offering. By 2022 Gartner estimates that 90% of all organizations buying public cloud IaaS will do some from companies with combined platforms, potentially solidifying Microsoft's healthy market position. 

Importantly, according to Gartner, most enterprise cloud customers generally stay with the same initial vendor for 10 to 15 years. Most IT departments are conservative by nature, and once a company moves its IT needs to one company's cloud servers (a process that can take several years), switching to a rival is a long, difficult, costly, and risky operations that can disrupt a company's business.

In other words, Microsoft has potential to become a duopolist in one of the largest and fastest-growing industries in tech. To help it maintain its lead and fend off numerous hungry competitors, the company has been working diligently to make sure it continues to upgrade and improve its offerings.

Microsoft doesn't just want to be a king of the cloud, it wants to build an entire ecosystem of services that creates high switching costs once it has won a customer's recurring subscription business. In fact, the company launched nearly 500 new Azure capabilities in fiscal 2018 alone, focused on customer workloads related to the Internet of Things and Artificial Intelligence. 

Another example can be found with Microsoft's Office 365 suite, which the company has made more feature rich than Alphabet's competing Google Docs. Owing to its free nature, Google Docs used to be the largest online document platform, but today Office 365 consumer has taken the crown (with over 165 million subscribers).

Many of these rent-not-buy software applications are presumably very sticky as well. Once a customer is trained to use a particular solution, such as Microsoft Excel, they become familiar with it and reluctant to restart the learning process with a different service in the future. 

Meanwhile, in enterprise, the company has focused on converting its strong position in offices around the globe (over 1 billion users) into integrated subscription-based offerings that help companies of all sizes meet almost any need. That includes everything from outsourcing their website and data storage needs, to organizing their accounting, payrolls, and various HR operations.

In other words, Microsoft is becoming a one-stop shop for all of its corporate customers' needs. More importantly, unlike in the past, Microsoft isn't trying to necessarily wall itself off. Rather than obsessively trying to control all of its applications, Microsoft has adopted a platform-neutral approach to app development.

For example, Azure (its business cloud platform) now supports various software platforms, including not only its own Windows but also competing Linux, as well as open source. This has helped Microsoft's app ecosystem balloon as it effectively crowdsources ideas from developers all over the world, who are designing, testing, and perfecting their applications on Microsoft's Azure platform while paying the company for the privilege.

Best of all, because all of this is software based, it's not overly capital intensive, so Microsoft's profitability has been steadily improving with operating margins topping 30% in 2018. Should the company continue gaining scale in these high-margin businesses, this trend seems likely to continue and help Microsoft's dividend continue growing at about a double-digit annual pace. 

Acquisitions have helped Microsoft's growth as well. Most notably, Microsoft bought LinkedIn for $26.2 billion in 2016. While many investors questioned the company paying so much for an unprofitable business, the deal was strategic because Microsoft wanted to integrate the world's largest professional social network into its cloud offering to enhance its value to existing and new customers.

Thanks to strong growth in customer engagement on LinkedIn, revenue from that part of the business has been growing consistently at 30% or more since Microsoft bought the company.

In 2018 Microsoft also bought GitHub for $7.5 billion. GitHub, like LinkedIn, is the dominant social network for its niche audience. Specifically, it's the "Facebook of programmers" with 31 million accounts and 100 million codes stored in its cloud-based servers. Approximately 1.5 million organizations use that code to operate, and Microsoft believes that shifting GitHub to Azure and exposing programmers to its ecosystem offerings will further strengthen its position in cloud computing.

Simply put, Microsoft's success across the cloud continues being helped by the firm's efforts to improve its subscription services, data analytics, and cloud offerings. A notable success story was announced in February 2019 when Exxon Mobil agreed to use Microsoft's cloud technology in its shale operations to boost profitability. The firm said this partnership was the industry's largest in cloud computing. 

Overall, Microsoft has made a very impressive turnaround, thanks to the strong leadership of its new cloud and subscription-focused CEO. The company has already taken a major chunk of the large and fast-growing cloud computing market while seamlessly integrating subscription versions of its legacy software into lucrative, recurring, and cash-rich businesses. 

This bodes well for Microsoft's long-term dividend growth prospects and potentially makes the stock a solid choice for a diversified dividend growth portfolio, especially for income investors looking for exposure to cloud computing.  

While Microsoft has become a resurgent giant in the last few years, there are still a few risks to keep in mind.

First, the company's legacy Windows operating system and Windows Server businesses are likely in long-term decline and will drag on sales growth and margins for the foreseeable future. This is because PC growth is expected to decline by about 1% a year through 2022 as consumers increasingly embrace PC alternatives such as Chromebooks, tablets, and smartphones. 

Fortunately, the company is doing well at transitioning its existing and enormous user base to its cloud subscription model, both on a consumer and enterprise level. In other words, as long as Microsoft can continue on its current path, its future looks bright. 

However, whether or not the company can continue executing on its cloud first approach is not guaranteed. Cloud computing is a red hot and booming sector that has attracted numerous enormous and well-capitalized rivals, including: 

Each of these giants is investing large sums of money to help companies with data analysis and business optimization. Microsoft is also investing heavily into artificial intelligence but seems to be slightly behind industry leader Alphabet.

Alphabet has two subsidiaries focused on winning the race to teach software to think on its own (and improve itself exponentially over time), courtesy of the world's largest data stream compiled from its entrenched online user base. 

Alphabet's goal is to create a superior offering to Azure and AWS that will underpin Google's own cloud offerings (current market share 9.5%). Urs Holzle, head of Google Cloud, previously stated that he even wants cloud service revenue to overtake advertising by the end of 2020. As of the end of 2018 Google Cloud was the fastest growing cloud service in the industry, demonstrating its traction. 

Whether or not that actually happens, the point is that Microsoft can't rest on its laurels as it did in the Ballmer days. The competition in cloud is fierce because the prize is literally becoming a cornerstone for the future of technology.

This means that Microsoft may have to continue ramping up investments in its cloud infrastructure which could hurt free cash flow growth in the short term. In fiscal 2018, for example, capital spending rose 43%, resulting in just 3.5% growth in free cash flow.

Since Nadella took over in 2014 capital spending has nearly tripled to $11.6 billion while R&D investment has risen by 41% to $14.7 billion. While Microsoft's fast-growing river of cloud and subscription-based operating cash flow can support much higher spending, the point is that the industry in which Microsoft competes is as expensive as it is large and fast growing.

As a result, investors should expect dividends to continue growing slower than earnings and long-term free cash flow. In 2018 Microsoft raised its dividend about 10%, below the 14% earnings growth it posted. Double-digit payout growth is still excellent, and the firm certainly has potential to continue rewarding shareholders with around 10% annual dividend increases. 

Finally, we can't forget that as Microsoft achieves ever-greater success and its cash position rises (over $125 billion of cash and short-term investments at the end of 2018), there is a risk that the company might repeat its history of terrible acquisitions.

For example, Steve Ballmer was famous for ill-conceived deals designed to restart Microsoft's growth engines, including the $9.5 billion acquisition of phone maker Nokia. That total failure resulted in a $7.6 billion write-down when Nadella wisely decided to abandon the Windows phone mobile operating system.

However, Nadella, despite being focused on cloud and mobile applications, isn't above potentially grandiose acquisitions, including paying $26.2 billion for LinkedIn in 2016.

The rationale behind this purchase was that LinkedIn's leading market position as the world's top professional social networks could be smoothly integrated into Microsoft's Azure-based cloud offerings and thus make its top priority businesses even more competitive.

So far it appears as if the plan is working, as Azure and commercial cloud businesses continue to grow like weeds. However, note that while LinkedIn sales are also growing strongly, the company was still generating accelerating losses for Microsoft in 2017.

Microsoft doesn't breakout LinkedIn's operating income anymore, which might be a sign that the strong growth is coming at the expense of worsening profitability.

Thus it's uncertain whether or not this purchase will ever actually become accretive to earnings. However, the good news is that Nadella's approach to M&A does appear far more disciplined than Ballmer's. Still, big M&A deals always come with high risks, especially in the case of GitHub, which has a rather ephemeral rationale behind it.

While owning the "Facebook of programmers" might eventually prove a smart strategic move, GitHub's success has always come from being a highly open solution which was platform neutral. Thus it's uncertain if merely hosting it in Azure will actually boost Azure's future customer growth. After all, many of Microsoft's largest cloud rivals are also on GitHub, and thus it remains to be seen whether or not they will allow their programmers to remain on the platform.

Only time will tell whether these strategic investments will actually pay off for shareholders, or whether they will result in steep write-downs as in the Ballmer years.

Microsoft has come a long way from the moribund growth years under Steve Ballmer. Current CEO Satya Nadella's strong focus on cloud computing and subscription services incorporated into Microsoft's sticky ecosystem has once again returned the company to strong double-digit sales, earnings, and free cash flow growth. 

While it's still too early to judge some capital allocation moves, such as the $26 billion acquisition of LinkedIn or $7.5 billion purchase of GitHub, it's clear that Microsoft is once again a dominant global technology company with an expanding lead in one of the most important growth markets of the future. 

More importantly, Microsoft is once more a company with the strong pricing power and large free cash flow generation needed to make it one of the best blue-chip dividend growth stocks in tech.