What's Next For Microsoft Corporation’s Dividend?

This former fast grower seems like it's returning to a growth phase, but should income investors stick around?

May 5, 2014 at 4:30PM

Years ago, investors wouldn't have cared about Microsoft (NASDAQ:MSFT) ever paying a dividend. However, in the last several years, the company's dividend has become increasingly important as the stock price stagnated. Now that Microsoft seems to have found some growth again, should investors worry that the dividend will be left behind?

Rising revenue is a good thing, right?
Microsoft has set out to become a devices and services company, and is putting products like the Surface 2, the Xbox One, and Office 365 front and center. It seems like the transformation is working, as the company's revenue increased by 8% compared to last year's quarter.

What is ironic is, two other former technology stars seem to be trying to reinvent themselves. Cisco Systems (NASDAQ:CSCO) used to be a huge growth story, but the company's 8% annual revenue decline is causing investors to question if the company's best days are behind it.

Intel (NASDAQ:INTC) used to be joined at the hip with Microsoft, however the company is facing challenges of its own. Intel also witnessed an annual revenue decline of 8% in the current quarter. The biggest difference between Microsoft, Cisco, and Intel, is Microsoft is executing on a game plan to transform the company whereas Intel and Cisco seem to be struggling to find direction.

Unfortunately, Microsoft's new growth is coming directly at the expense of its gross margin. Six months ago, Microsoft reported a 14% increase in revenue, but to achieve this growth the company's gross margin declined by 7.3% on a year-over-year basis.

In the last three months, Microsoft's 8% revenue growth came at the cost of a 5.1% annual decline in gross margin. Microsoft is making headway in its consumer business with 40% revenue growth in hardware. However, hardware is historically a lower-margin business than software. If this trend continues, Microsoft's gross margin will likely continue to be under pressure.

Microsoft needs to stick to what it does best
With hardware growth and OEM software revenue still declining, Microsoft needs to make sure it can maintain its momentum in its commercial and Office businesses. On the consumer side, Office 365 Home witnessed a nearly 30% growth rate in subscribers.

On the commercial side of things, Microsoft, Cisco, and Intel are all benefiting from increased business spending. However, the difference in quality of growth between the three is significant. Microsoft grew commercial revenue by 7%, and sales of Office 365 and Azure both posted growth of more than 100% annually.

Cisco's product sales were down 11% and products still represent the majority of the company's revenue. Intel's Data Center Group reported revenue growth of 11%, but this division still makes up about one quarter of the company's overall sales.

Strength of commercial sales is a big deal to Microsoft as this division is responsible for more than 50% of the company's revenue. In addition, the company's commercial licensing gross margin exceeds 90%. However, as long as overall consumer sales growth outpaces commercial growth, Microsoft's cash flow growth may be muted.

What's the bottom line?
Microsoft's consumer growth carries a lower margin than its commercial business, and is growing faster. With gross margin compression a reality facing the company for the foreseeable future, Microsoft's cash flow is facing a serious slowdown.

In the last three months, Microsoft's core operating cash flow (net income + depreciation) actually declined by 3%. By comparison, Intel's operating cash flow decreased by less than 2%, and Cisco reported a six month cash flow increase of just under 2%. Given that Microsoft witnessed the strongest revenue growth of the three, it's troubling that the company's cash flow is declining.

In fact, the clearest picture of Microsoft's dividend future can be found looking at the company's core free cash flow payout ratio. In the last three years, the company's average ratio was 30%. In the last four quarters, this ratio has risen to almost 38%, and in the last three months it increased again to 40%.

The point is, Microsoft is attempting to transform into a devices and services company. While this is leading to faster revenue growth, the company's gross margin and cash flow are taking a hit. If this continues, investors who may be looking forward to significant dividend increases may be disappointed.

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Chad Henage owns shares of Cisco Systems and Microsoft. The Motley Fool recommends Cisco Systems and Intel. The Motley Fool owns shares of Intel and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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