Microsoft's (NASDAQ:MSFT) dividend doesn't look quite as attractive as it did a few years ago. The dividend yield is currently just 2.6%, higher than the S&P 500 average, but a bit lower than other tech giants like Cisco and IBM. Microsoft's stock has very nearly doubled over the past three years, and while the dividend has been increasing during that time, it just hasn't kept up.
Despite this, Microsoft remains one of the top dividend stocks in the technology sector. Here are two reasons why.
Microsoft's business is strong
The consumer side of Microsoft's business gets a lot of attention, but it's the commercial side that matters the most. In fiscal 2014, the commercial segment generated more than two-thirds of the company's total gross profit, a fraction that is getting bigger as the commercial business continues to surge. Over the past two years, commercial revenue rose by 18.7%, and commercial gross profit increased by 15.5%.
This growth is despite a weak PC market, the rise of smartphones and tablets, and the rapid growth of cloud computing. These certainly had a negative effect on Microsoft's consumer business, causing consumer licensing revenue to decline, but the commercial business has remained unscathed. Microsoft is heavily embedded in the enterprise, with a 17.8% share of the global enterprise software market, more than twice that of its closest competitor, and high switching costs help protect the company's vast profits.
There are certainly challenges to Microsoft, like Google's attempt to dethrone Microsoft Office with its own productivity apps, but so far these haven't had much of an effect. Microsoft is one of the leading cloud computing companies as well, investing billions over the past few years building out its data centers, thus ensuring that its software continues to be used regardless of the delivery method. In short, Microsoft's business is strong and resilient, an important quality that helps ensure the sustainability of the dividend.
There's plenty of room for growth
Microsoft's dividend has been growing at an annualized rate in excess of 14% over the past decade, and while the most recent dividend increase was a lower 10.7%, double-digit dividend growth is highly desirable if it can be maintained. Thankfully for Microsoft investors, the company has plenty of room to grow its dividend further, even if earnings growth continues to be dragged down by the consumer business.
During the past 12 months, Microsoft has paid out roughly $9.3 billion in dividend payments, according to S&P Capital IQ data. That seems like a lot, but during that same period Microsoft recorded net income of $21.4 billion and free cash flow of $26.8 billion. This puts the payout ratio at 43% with respect to the net income and just 35% with respect to the free cash flow.
Some of the leftover earnings have gone toward buybacks, but Microsoft can easily afford to continue to grow the dividend faster than earnings growth for years to come. During the past five years, Microsoft has grown the amount of cash on the balance sheet from $36.8 billion to $89.2 billion -- in other words, the company has more cash than it knows what to do with.
One issue is that much of this cash is held overseas, and that can't be used for dividends or buybacks without paying taxes to bring it back into the United States. What Microsoft can do is issue debt, borrowing at extremely low interest rates, in order to fund capital returns to shareholders. Since the end of fiscal 2010, Microsoft has increased its debt by about $16.7 billion, and it has been able to leverage its AAA credit rating to secure rock-bottom interest rates.
This overseas cash may be limiting how quickly Microsoft can grow its dividend, but with analysts expecting mid-single-digit earnings growth from Microsoft over the next few years, and with a little more than half of Microsoft's revenue coming from the United States, Microsoft should be able to continue to grow the dividend at a double-digit rate going forward.
Microsoft is a top dividend stock not because its yield is abnormally high, but because the business is extremely strong, and the dividend has a long runway for growth. Microsoft is the overwhelming leader in the enterprise software market, and the stock deserves a place in any dividend portfolio.
Timothy Green owns shares of Cisco Systems and International Business Machines. The Motley Fool recommends Cisco Systems, Google (A shares), and Google (C shares). The Motley Fool owns shares of Google (A shares), Google (C shares), International Business Machines, 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.