Will Microsoft’s Big Problem Cause Losses For Shareholders? – Microsoft Corporation (NASDAQ:MSFT)

By Bob Ciura

It is nearly inconceivable to seek out something fallacious with Microsoft Corporation (MSFT). The firm is rising at a excessive charge, due to its profitable transition to cloud software program and companies. It additionally has a wonderful steadiness sheet, and is a robust dividend progress inventory.

Microsoft is a Dividend Achiever, a bunch of shares with 10+ consecutive dividend will increase. You can see all the record of all 265 Dividend Achievers right here.

At the identical time, Microsoft inventory has had an unstoppable rally since 2009. Shares have appreciated by greater than five-fold off the Great Recession low.

MSFT knowledge by YCharts

The enormous rally has been due, partly, to Microsoft’s earnings progress. But it has additionally been as a consequence of a rising price-to-earnings a number of. Microsoft’s valuation has expanded considerably, and is now dangerously above its common over the previous 10 years. In addition, Microsoft’s dividend yield has sunk to a multi-year low.

While there isn’t any scarcity of accolades an investor can heap on Microsoft as a enterprise, the inventory doesn’t look like a bady funding at the moment.

Business Overview

Microsoft is a expertise big. It manufactures a variety of software program, together with its flagship Office and Windows. Its different major merchandise embrace the Xbox online game enterprise, Surface tablets, and it additionally owns LinkedIn.

Microsoft has had a variety of momentum just lately, due to its transition away from the non-public pc. Sluggish PC gross sales around the globe compelled the corporate to maneuver into the cloud. Its cloud choices, comparable to Azure and Office 365, are performing effectively.

In fiscal 2017, Microsoft’s adjusted income elevated 5%. Cost controls and share repurchases fueled 19% earnings-per-share progress. The firm ended the fiscal yr on a robust observe. In the fourth quarter, income grew 10%, whereas adjusted earnings-per-share soared greater than 40%.

Source: 2017 Earnings Presentation, web page 9

The firm is off to a bang to begin fiscal 2018. Microsoft beat badyst expectations throughout the board for the fiscal first-quarter. Earnings-per-share of $zero.84 beat by $zero.12 per share, whereas income exceeded estimates by almost $1 billion. Revenue rose 12% year-over-year, whereas earnings-per-share elevated 17%.

Growth Prospects

Microsoft’s progress previously two years has actually impressed. However, wanting additional again, Microsoft has elevated diluted earnings-per-share by simply 5% per yr, previously 5 years and 10 years.

To make sure, Microsoft has largely labored previous the expansion slowdown of 2014 and 2015, due to the cloud companies. And, Microsoft is more likely to proceed its progress transferring ahead, because the shift to the cloud is ongoing. Microsoft’s Office business income elevated 10% final quarter, as a consequence of 42% progress for Office 365 Commercial. Separately, Dynamics income elevated 12%, pushed by the shift to Dynamics 365.

Total business cloud income elevated 55% final quarter. Gross margin for the business cloud companies rose by eight proportion factors, which is a outstanding mixture of income progress and margin enlargement.

Source: Q1 Earnings Presentation, web page 5

There are only a few criticisms to be made concerning Microsoft’s enterprise overview, or progress prospects. However, one space of concern is Microsoft’s steadiness sheet, which has taken on an excessive amount of debt to finance its strategic investments.

Microsoft ended fiscal 2017 with long-term debt of $104 billion. Five years earlier, it had $24.5 billion of long-term debt. Microsoft has raised enormous quantities of debt for its cloud investments and M&A, such because the $26 billion acquisition of LinkedIn. These investments are an enormous motive for Microsoft’s progress previously yr. But as leverage will increase, there may be much less room to tackle further debt to finance progress.

Another adverse facet of Microsoft inventory is its lofty valuation, which makes the inventory pretty unattractive as an funding.

Valuation & Expected Returns

Microsoft had diluted earnings-per-share of $2.71 in fiscal 2017, in line with the corporate annual report. Based on this, the inventory has a price-to-earnings ratio of 31. Using adjusted earnings-per-share of $three.31, which excludes non-recurring expenses, ends in a price-to-earnings ratio of 25.four. This is best, however in both case, Microsoft is buying and selling effectively above its historic common.

According to ValueLine knowledge, Microsoft has held a median price-to-earnings ratio of 14.1 over the previous 10 years.

Source: Value Line

Microsoft’s share value good points since 2011 have been fueled largely, by its rising valuation a number of. In the previous 10 years, the corporate grew earnings-per-share by 5% per yr, in line with ValueLine. Today, Microsoft’s price-to-earnings ratio is roughly 80% above its 10-year common. If Microsoft had been to expertise contraction of the price-to-earnings a number of, it will have a major affect on the share value.

The different draw back of shopping for a inventory at a far increased valuation, is that the investor should settle for a low dividend yield. As you’ll be able to see within the following chart, Microsoft’s dividend yield has steadily fallen over the previous a number of years.

MSFT Dividend Yield (NYSE:TTM) knowledge by YCharts

Microsoft presently yields 2%, which is on par with the S&P 500 Index common. The firm does increase its dividend annually, however its dividend progress charge has slowed. The most up-to-date dividend enhance of seven.6% was effectively beneath Microsoft’s five-year compound annual dividend progress charge, of 13%.

Final Thoughts

Microsoft is a good firm. As a inventory, it’s not as nice. Shares have handsomely rewarded traders over the previous 5 years. But whether or not the subsequent 5 years can be as rewarding, is a special query. Microsoft will seemingly proceed to develop income and earnings, however the inventory might nonetheless expertise a contracting valuation a number of.

In order for Microsoft’s great rally to proceed transferring ahead, the corporate must preserve surpbading expectations, which preserve climbing together with the price-to-earnings ratio. With a excessive valuation and a low dividend yield, the risk-reward doesn’t appear to be in traders’ favor proper now.

Microsoft is a good enterprise. But there are top quality shares buying and selling at significantly better costs – even in at the moment’s overvalued market. Our service Undervalued Aristocrats offers actionable purchase and promote suggestions on among the most undervalued dividend progress shares round. Click right here to study extra.

Disclosure: I/we have now no positions in any shares talked about, and no plans to provoke any positions throughout the subsequent 72 hours.

I wrote this text myself, and it expresses my very own opinions. I’m not receiving compensation for it (aside from from Seeking Alpha). I’ve no enterprise relationship with any firm whose inventory is talked about on this article.

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