Microsoft Corporation (MSFT) Stock Analysis: Buybacks and Dividends 

Microsoft stock does just fine when it comes to returning capital to shareholders

Microsoft Corporation (NASDAQ:MSFT) is a large, complex company. So while an occasional update on the news is nice, anyone who owns Microsoft stock, or is considering owning it, should take a deep, thorough dive into all of its nooks and crannies.

Microsoft Corporation MSFT Stock Analysis

The process is no different whether we’re examining a mega-cap technology company or a small-cap manufacturer of widgets. Do the work set out in this article — as well as a few that will follow in the coming days — and you’ll be better prepared to invest in (or avoid) MSFT.

It’s not a guarantee you’ll be successful, mind you, but it’s a good place to start.

Why Even Offer Buybacks and Dividends?

In this first article covering Microsoft stock, I’ll look at the return of capital to shareholders: specifically, through the use of stock buybacks and dividends. While investors generally think of this process as a way for companies to reward shareholders, in truth, when done effectively, it’s the best way for companies with high returns on invested capital to deal with excess cash.

McKinsey & Company have written a great article (don’t be put off by its 2011 publication date) that explains the process of returning capital to shareholders. You would be wise to read it. In it, authors Bin Jiang and Tim Koller, provide an example of a company faced with the dilemma of what to do with excess cash. I’ll list those example figures here, followed by Microsoft’s numbers:

  • $1 billion in annual after-tax profits (Microsoft had $16.8 billion in fiscal 2016)
  • 25% return on invested capital (Microsoft had ROIC of 14.2% in fiscal 2016. As recently as 2013 it was 25%.)
  • Projected annual revenue growth of 5% (Microsoft’s 5-year average is 4.1%.)

Essentially, the authors came to the conclusion that the company would need to reinvest about 20% of the $1 billion in after-tax profits to maintain its rate of growth; the remaining $800 million would have to be invested by the company in opportunities that would generate 25% revenue growth by necessity of its 25% ROIC.

In other words, it’s virtually impossible for a company to find enough good opportunities to successfully do this on an annual basis. Hence, there is an eventual need for dividends and stock buybacks.

Sweetening Microsoft Stock

In Microsoft’s case, it has to figure out what to do with about $17 billion annually. That’s no easy task. In fiscal 2016, MSFT paid out $11 billion in dividends and repurchased $16 billion of Microsoft stock. That’s $27 billion returned to shareholders — considerably more than the after-tax profits for the year.

What gives?

One generally considers a company’s free cash flow — net cash from operations less capital expenditures — rather than net income when evaluating a company’s capital allocation. In Microsoft’s case, it had free cash flow in 2016 of $25 billion, which still leaves a $2 billion shortfall. And then we have debt repayment ($2.8 billion) and acquisitions ($1.4 billion) thrown into the mix.

Call it a $6.2 billion free cash flow shortfall.

Don’t worry. Microsoft’s not going out of business. MSFT has $113 billion in cash and cash equivalents on its balance sheet. If it continues at its current pace of growth, it would take almost 19 years of free cash flow shortfalls to erase its massive cash hoard.

Could Microsoft distribute more cash to shareholders? For sure. However, the company historically has had higher returns on invested capital than it currently generates. It’s important that management holds some of that cash back should “big” acquisition opportunities — such as LinkedIn Corporation (NYSE:LNKD) — present themselves.

A possible solution would be for it to implement some kind of special dividend program that doles out excess cash every two to three years as these levels rise above the $100 million mark — 2016 was the first time over the century level.

Still, Microsoft paid out $27 billion in dividends and stock buybacks in 2016. That’s 160% of its 2016 net income. Put another way, it’s approximately 26% of the average cash and cash equivalents on its balance sheet over the past 12 months.

MSFT has done a lot.

Microsoft’s Dividends

Focusing first on dividends, Microsoft’s dividend payout ratio (dividends paid as a percentage of net income) currently sits at 66%. The average S&P 500 dividend payout ratio as of June 2016 was 39.1%. Unbelievably, a total of 44 companies have ratios above 100%.

On the dividend front, it’s safe to say that Microsoft is shareholder-friendly while remaining prudent about its excess cash. Its 2.7% dividend yield isn’t smoke and mirrors.

Microsoft’s Stock Buybacks

Moving on to stock buybacks, a quick look at Microsoft’s 10-year history shows that it has reduced its share count by 22% to 7.8 billion shares. Microsoft repurchased $4 billion of its stock in Q1 2016 and $3.6 billion in the three subsequent quarters. According to FactSet, Microsoft is one of the top 10 S&P 500 companies when it comes to buybacks.

A useful exercise when evaluating a company’s stock buybacks in a given period is to compare what it paid per share to the average price of its stock during that period.

In 2016, MSFT bought back 294 million shares at an average price of $50.34. In the 12 months between June 30, 2015, and June 30, 2016, you’re looking at …

  • A high of $56.85
  • A low of $41.66
  • An average of $49.26

Microsoft paid $1.08 per share higher than the average.

I’d say Microsoft did a mediocre job of stock buybacks in 2016 primarily because it adhered to a set amount per quarter as opposed to buying in a timely manner. In its defense, it’s not easy buying back stock when you have so much to buy. It’s a lot like driving a thousand-foot cruise ship — it can’t turn on a dime.

Frankly, most companies are poor purchasers of their own stock. The fact that MSFT is among the leaders in the S&P 500 should be good enough for shareholders.

Bottom Line

While there are reasons to think twice about making an investment in Microsoft stock, its policy of dividend and stock buybacks isn’t one of them.

Microsoft is a responsible steward of shareholder capital in my opinion.

As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.

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