A growing number of investors are clamoring for income, and for good reason. Stocks that pay dividends provide a meaningful margin of safety when markets turn south. Nowhere was this more evident than in the financial crisis and ensuing market collapse in 2008 and early 2009, when dividend payments at least helped investors navigate an environment of brutal paper losses. When markets soar, dividends are the perfect icing on the cake that boost returns even higher.
In the technology sector, two of the premier dividend stocks are Cisco Systems (NASDAQ:CSCO) and Microsoft Corporation (NASDAQ:MSFT). Let's see how these two technology behemoths stack up against one another in a dividend showdown.
Both companies are in the middle of turnarounds
Cisco and Microsoft have one big thing in common: They're each in the process of significant turnaround efforts. For Cisco, the task is expanding beyond just routers and switches, and into new areas with better growth prospects. The company has aggressively pushed into new areas of focus, such as security, data centers, and software. In addition, Cisco is trying very hard to improve its standing in new markets. The emerging markets were a major source of pain for Cisco last year.
The timing for these initiatives is just right, since it's clear Cisco is struggling. Revenue and earnings per share declined 3% and 20%, respectively, in fiscal 2014. In addition, Cisco's free cash flow declined 5%. However, this isn't affecting Cisco's ability to pay attractive dividends to shareholders. That's because Cisco still generates solid cash flow overall. Cisco's free cash flow totaled $11 billion in fiscal 2014. The company distributed $3.7 billion worth of dividends last year, which represents just one-third of the company's free cash flow.
This is why Cisco has raised its dividend at high rates since instituting its payout in 2011, even though growth is stagnating. Cisco has increased its dividend by 46% compounded annually in that time. It now offers a healthy 3% yield based on the stock's recent closing price.
Microsoft's turnaround is gaining traction
Meanwhile, Microsoft's own turnaround is going very well. For years, Microsoft was feared to be too reliant on the personal computer. There was a pervasive sense of fear that in the coming smartphone era, Microsoft's core software and operating system would suffer. However, nothing has been further from the truth. Microsoft has made huge gains in its cloud-based software and services.
For example, Microsoft's commercial cloud revenue doubled last year, to $4.4 billion. In all, its devices and consumer segment posted 42% revenue growth last year. Microsoft's software is doing very well, particularly when it comes to the cloud, and the company is benefiting from strong sales of its Xbox One console as well.
Microsoft's fiscal year ended in June, and the results were very strong. For the full year, revenue and diluted earnings per share grew 11.5% and 2%, respectively, versus the prior year. Free cash flow was $26 billion, which increased 8% year over year.
Like Cisco, Microsoft distributes only one-third of its free cash flow via dividends. Its dividend growth over the past five years has clocked in at 16% compounded annually. Microsoft stock yields 2.4% at Tuesday's closing stock price.
Which company has the edge?
At first glance, you might be tempted into thinking Cisco is the better dividend stock for its impressive dividend growth and higher yield. But Cisco's huge dividend growth mostly took place shortly after initially instituting its payout three years ago. It's simply caught up to where other technology dividend payers, like Microsoft, already were.
Cisco's recent dividend increases have been much more modest than its three-year average, and it's likely future dividend growth won't match Microsoft's. Microsoft is putting up much more impressive growth than Cisco, as its turnaround has been more successful so far.
Even though Microsoft's current 2.4% yield trails Cisco's 3% yield, Microsoft is likely to catch up, if its future dividend growth runs ahead of Cisco's, as I suspect it will. As a result, because of its better dividend growth prospects going forward, I favor Microsoft stock over Cisco's for dividend investors.
Bob Ciura has no position in any stocks mentioned. The Motley Fool recommends Cisco Systems. The Motley Fool owns shares of 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.