Dividend-focused investors don't often find themselves treading in the tech sector. However, the particular tech stock that we'll discuss here just happens to offer one of the best opportunities for substantial dividend growth available in the market today.
Now, notice I say "dividend growth," as the firm's current 1.25% dividend yield isn't exactly going to knock your socks off -- particularly given that this figure is lower than the 1.9% offered by the S&P 500 (AMEX:SPY). But for those seeking a future income opportunity covered in a growth wrapper, this could be an excellent portfolio supplement.
Cash with a side of microchips
Perhaps you've heard of a little software nugget called Microsoft (NASDAQ:MSFT). I realize that this venerable tech titan can inspire a range of emotions: love and adoration from newly efficient users, and loathing from those with monopolistic fears.
But beyond all that, there's no denying Mr. Softy is one of the planet's most profitable businesses. Though the days of hundredfold annual growth are likely behind it, the software giant has morphed into a consistent cash machine that has developed a taste for dividends, and we like that.
Microsoft enjoys a 90% market share in its core software business (i.e., Windows and Office), and I still fail to see any significant competition on the horizon. However, it does have a problem: It generates far more cash than it can profitably reinvest in its various business lines. Of course, that's a very good problem to have.
The payoff
To help alleviate this, Microsoft began paying a fairly scrawny $0.16 dividend just two years ago, but has since doubled that sum to the current $0.32 payout. I believe there's a lot more where that came from. Indeed, the future Microsoft could be akin to the past Philip Morris (NYSE:MO) in terms of dividend growth and income potential.
Some of you may recall that I actually asked Mr. Gates to fork over some of the company's vast cash reserves in a past article. As luck would have it, I reran the piece on July 19, 2004, and the company announced its $3 special dividend the following day. (I assure you this was coincidental, as -- last time I checked -- my Bill Gates hotline still wasn't operational -- but I digress.)
Consider that Microsoft's current dividend costs the company less than $3.5 billion per year. That may be quite a bit of change for the local 7-Eleven (NYSE:SE), but since Microsoft recently had a cash balance of $37.5 billion -- even after its December 2004 payment of the massive $3-per-share special dividend -- it could fund the dividend from its cash balance alone for 10 years.
Microsoft also generates more than $13 billion a year in free cash flow (FCF), which covers the dividend another 3.75 times over. Not enough? I've got one more for you: The company will be buying back an additional $30 billion of its own stock over the next four years. That will result in fewer shares outstanding on which the company must pay dividends, which means that even a doubling of the dividend during that time would result in a much smaller increase in the actual cash outlay.
With the means for such hefty dividend increases, today's investors could achieve a much higher effective yield going forward (i.e., the dividend yield based on your original purchase price as opposed to the current stock price).
The lure of world domination
Of course, these are all reasons that I've counted myself a Microsoft shareholder since November 2003. Though I'd sometimes complained about the quality of the company's products, I started to appreciate the firm's market-trouncing abilities and the value in the shares.
That said, I believe you have an even better opportunity at hand, because the stock is now cheaper than when I bought it. Despite its awesome stats, Microsoft is trading at just over 18 times FCF. Not a bargain-basement price, but for numbers like the ones I've just mentioned, I'm OK with the slight stretch. Unless we see a large overall market correction, it's just plain unlikely investors will get many chances to buy the shares lower than they are today.
I peg the value of the stock at $32 a stub, and it's conceivable that today's buyers could be sitting on an effective yield of more than 3.5% in just five years. How? Well, I've based this on the relatively conservative assumption that the company could easily pay out 40% of its potential 2010 FCF per share of $2.27, resulting in a future annual dividend of $0.91. That payout is very achievable, as it would still leave plenty of cash for Microsoft to plow back into its business.
This is definitely not a bad yield for a company that could also generate considerable capital appreciation. Again, income investors shouldn't let the 1.25% current yield hold them back, as brighter days are ahead. Further, it's important for even income investors to keep a few growth engines on hand that have the ability to rev a little higher than their overall portfolios. This is just such an opportunity.
Who knows, Apple (NASDAQ:AAPL) may boast the more stable operating system, but it's awfully hard to say no to massive payments of cash, so I'll stick with world domination for now. (As Anakin Skywalker taught us, the dark side is oh so alluring).
The Foolish bottom line
I shared these same feelings with subscribers of our Motley Fool Income Investor newsletter back in March of this year, and though other analysts have since adopted the same viewpoint, the stock price remains virtually unchanged since then. I believe this offers investors an opportunity to lock in both substantial dividend growth and compelling, low-risk total return potential.
With its monopolistic tendencies behind it and sizable cash flow ahead, investors seeking growth and income should do quite well with the stock over the next five to 10 years.
Mathew Emmert is a true oddity: Though he's a total Star Wars geek, he's also happily married. Go figure. He owns shares of Microsoft and Philip Morris (now Altria), and he's the chief analyst ofMotley Fool Income Investor. The Motley Fool has a disclosure policy.
