Microsoft (NASDAQ:MSFT). The name alone inspires many deep-seated emotions:
- Love and adoration from millions of people whose lives have been made easier through the power of the Windows operating system
- Loathing from the millions of people who have encountered the dreaded "blue screen of death"
- Fear in the hearts of competitors everywhere
Beyond all that, however, we are undeniably talking about one of the most profitable businesses on the planet. Though the days of hundredfold annual growth are likely behind it, the maturing software giant is still a cash flow machine.
This company's financials read exactly as you'd expect those of a market dominator to read. Mr. Softy has a profit margin over 30%. Its return on equity is a solid 16.5%, and its return on assets is a stunning 12.9%. In addition, it has over $51 billion in cash -- that's nearly $5 per share. What's more, it carries zero debt, so that cash is just sitting there waiting for an opportunity to burn a hole in someone's pocket.
The firm isn't resting on its laurels, though. It's not content with simply looking back nostalgically on what it has accomplished over the years -- in fact, far from it. The software kingpin currently generates more than $12 billion in annual free cash flow (FCF), and is putting its fingers into virtually every new technology imaginable.
Despite these awesome stats, Microsoft is trading at just 21 times forward earnings, and at 22 times FCF. It's also trading at a discount to intrinsic value based on a discounted cash flow analysis. That's not a bargain-basement price, mind you, but for numbers like the ones mentioned above, you often have to be willing to stretch a bit.
The lure of evil
Now, to spill the beans, these are all reasons that I now count myself as a Microsoft shareholder, having officially joined the dark side two weeks ago on Nov. 24. Despite my past complaints about the quality of the juggernaut's products, I simply could no longer deny the market-trouncing abilities of this company and the value in the shares.
There is no denying that shareholders have been very well rewarded over the long haul. After all, the term "Microsoft Millionaire" applies to many who've held the stock for 10 years or more.
But, that said, there's another big reason that I finally took the plunge: Dividends (yes, dividends). Actually, it wasn't just dividends, but big, fat, monstrous dividends. OK, if you're now wondering whether or not we're talking about the same company, let me clarify: I'm talking more about Microsoft's transition to a dividend payer rather than its current dividend payout. Indeed, the company's current 0.61% yield is somewhat puny.
If it were more like 3%, I wouldn't be writing this article because the stock would be a perfect selection for Motley Fool Income Investor. However, though it doesn't have the punch of a powerful payer today, I think the company has the potential to become a tremendous dividend diva going forward.
I'd like more cash please, thank you
I mentioned that shareholders have done well with the company's stock. This is, however, an extraordinary company, so it should provide an extraordinary return. But this is also a maturing company, and a smaller portion of that return will come from internal growth than in years past. So, where is the extra kick going to come from?
Well, it needs to come in the form of the company passing along a portion of its substantial cash flows to shareholders. But, you say, given their double taxation, I thought dividends weren't a very efficient way to return money to stockholders.
That's the traditional company line, but it's really nonsense. Even when we forget about the fact that the maximum tax on dividends has been lowered to 15% -- making it equal to that of capital gains -- dividends still make perfect sense.
There are many other benefits that go along with being a material dividend payer. Purveyors of dividends tend to be less volatile, for instance, because the yield rises as the stock falls, and that helps to support the shares. Also, significant yields can invite a different kind of investor: one with a long-term, income-oriented focus, which can lend further stability to the stock.
If all this sounds familiar, you may be fondly recalling an article written just over a year ago by our very own Rex Moore, who asked Mr. Softy to start paying a dividend. Lo and behold, the company did just that. (We've noticed that whenever we see Bill Gates on television, Rex is nowhere to be found, so we're beginning to think Bill and Rex are the same person. We'll let you know.)
The undeniable
No matter where you come out on the dividend debate, at the end of the day this company has a problem: It makes more money than it can profitably reinvest in its business. Now, that's an awfully good problem to have, but it's still a problem.
Though they're very good at developing software, geeks are apparently not so good at investing (which blows the theory many hold about me). Over the past few years, the Microsoft management team has written off nearly $4 billion in investments it plunked into now-bankrupt companies such as Lernout & Hauspie, Teligent, USInternetworking, and Winstar Communications. Ouch. Frankly, I'd rather have the money in my hands than theirs.
But what about competition, you ask? Paying out a large dividend wouldn't leave the company enough money to defend itself from this extremely competitive market. Just take a look at IBM (NYSE:IBM).
First off, IBM is still around despite its significant blunders, and that phenomenon also bodes well for a powerhouse like Microsoft. But more to the point, Bill could raise the dividend by three times and still have enough greenbacks left over to buy up every competitor on the face of the planet and shut them down, effectively squashing free markets and the competitive spirit in every corner of the globe. OK, maybe that's a little strong, but you get the idea.
Currently, the company is paying out just 17% of FCF, and it's facing an increase in demand for its products. That means even more substantial cash flows are likely in the future, which leaves room for the firm to increase the dividend to a heartier level over the next few years.
The Foolish bottom line
By investing in Microsoft, I may have lost my morals, my scruples, and my marbles (though that last one isn't really related to buying the stock). However, I have done so with the hope that the company is on the verge of recognizing its potential for a powerful payout.
Don't get me wrong. I'd be just fine with some hundredfold growth, but I think the best way for the company to create shareholder value over the long term will be to give up some cabbage. Pay up, Mr. Softy.
Mathew Emmert doesn't consider himself an evil person, but he does own shares in Microsoft. He also offers the readers of Motley Fool Income Investor two stock picks a month -- maybe someday Microsoft will make the grade. The Motley Fool has a disclosure policy .
