Another Dividend Play for a Lifetime

A few months ago, I highlighted McDonald's (NYSE: MCD) as the dividend play for a lifetime. Since then, the stock has made a straight path upward, climbing a dividend-adjusted 9.2%, outpacing the S&P's increase of 5.8%. I highlighted the company's hidden assets, its shareholder-friendliness, and its rapid dividend increases.

I'm back today to recommend another dividend play for a lifetime. The company is Microsoft (Nasdaq: MSFT), whose product you're probably using right now. Like McDonald's, the company is plumping its dividend at a torrid pace and has a defensible business franchise, meaning it can boost those payouts for years to come.

High growth meets high yield
Microsoft has been an exceptional dividend star over the past few years. It has fattened its dividend on average by 15% over the past five years -- a clean double in that half-decade. That's a solid gain, but it looks like Microsoft has plenty more increases in store. While its yield stands at 2.6%, well above that of the average S&P stock, it's not the stuff of legend. But as an income investor, you need to balance high yield with high dividend growth. The growth rate is as vital as the dividend.

Take a look at the following dividend darlings:

Source: Capital IQ, a division of Standard & Poor's.
Frontier dividend reflects recent change down to a $0.75 annual dividend rate.

Microsoft and Johnson & Johnson both offer lower yields, but with their excellent consumer franchises (despite J&J's current problems) they have greater potential for high year-after-year increases. In fact, as Microsoft's growth slows from the torrid pace of yesteryear and it increasingly offers a substantial payout, the company is reorienting itself as a more shareholder-friendly organization.

Contrast their payouts with those of Frontier and Annaly. The latter offer sizable dividends now, but the prospect for future increases is much dimmer. Frontier has done a good job under CEO Mary Wilderotter of milking profit from a declining fixed-line telecom business. The company recently ratcheted back its payout as it beefs up operations recently purchased from Verizon.

Annaly has been pumping out mighty dividends over the last couple of years. As interest rates plummeted, Annaly's net interest margin fattened, as did its payouts. Annaly could be a great play as long as low inflation remains, but the company is monitoring interest rates closely. If and when rates increase -- more likely, skyrocket -- the company could see a disruption in those payouts.

Now, I'm not criticizing investors in those companies. Heck, I'm an investor in Frontier and Annaly, because I still see legs in the investments. Frontier still looks undervalued to me, and I think deflation or at least very low inflation, will be with us for quite a while, so Annaly's gaudy payouts should continue in the meantime. But I do like to mix high yields with high growth to obtain a better blended payout. I also own shares of Microsoft, having upped my position recently, as I promised when I pitched it as a Motley Fool "11 O'Clock Stock" recently.

Microsoft for life
Microsoft has given every indication that it intends to pay out a substantial portion of its free cash flow. Over the last decade Mr. Softy has returned $170 billion in dividends and repurchases and it still has $24 billion remaining on a repurchase authorization. Over the last four quarters, the company has doled out $4.5 billion in dividends and it just recently boosted its dividend by 23%, so you can bet more will be coming your way. Microsoft is methodically transforming itself into a dividend dynamo.

Even better, the stock itself is cheap. It trades at just 12 times trailing earnings. Back out its massive net cash hoard of $30 billion, and you're looking at a business trading at just 10 times trailing earnings. Using Ben Graham's growth formula, Microsoft's price implies earnings growth of less than 1%. But the company has done much, much better than that over the last five years: Earnings per share have climbed 13.3% annually on average. That pales compared to annual EPS growth at rival Apple (Nasdaq: AAPL), of course, at 62%, but you do have to pay a higher multiple for Apple. And Microsoft has few expectations baked into its prices, meaning little downside risk. In this environment, that's key.

Microsoft has very defensible businesses in its Windows and Office segments, and it has the ability to successfully defend them without major difficulty. Both of these segments have at least 90% share, and each generated about $12 billion in operating profit last year. Its Server division added another $5 billion. Despite low-return efforts in mobile software, search, and music, Microsoft still has tremendously dominant, tremendously profitable franchises.

And it's working hard to promote their dominance as we move into the cloud-computing arena. With a comprehensive set of software solutions, the company can offer discounts to businesses for going all-Microsoft. In addition, it's been working to tie its software into a seamless set of solutions. So the software giant is taking many good steps to lock in and even strengthen its monopolistic position.

Contrast that competitive position with that at Altria (NYSE: MO), where the company is hounded by government regulators, higher taxes, and waning smoking rates. It is besieged from every direction, but the company has committed to paying out 80% of its profit as dividends, so it now sports an eye-bulging 6.2% yield. That's great for current yield, but it's easy to imagine scenarios in which Big Tobacco's significance wanes over the next couple of decades, or sooner.

So it could make a lot of sense to match up Microsoft's lower current yield and brisk growth rate with Altria's higher yield but cloudy future. That's one way to go, in any case.

Foolish bottom line
A tech titan. A cheap price. A larded-up and growing dividend. I might just add more Microsoft shares to my portfolio. How 'bout you? Let me know what you think in the comments box below.

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