Microsoft – a Little bit Late for the Party, Still Growth to Come from the Clouds

Microsoft is the best known and most important software company in the world. Along with its famous line of software products, Microsoft also offers various services such as servers (including cloud systems), business solutions (support and consulting), entertainment (Xbox) and other online services.stock report

-Seven Year Revenue Growth Rate: 9.71%
-Seven Year EPS Growth Rate: 8.23%
-Seven Year Dividend Growth Rate: 12.56%
-Current Dividend Yield: 2.55%
-Balance Sheet Strength: Strong

Overview

We all know Microsoft for their Windows operating system and Office Suite. At several occasions in time, we have seen competitors try to steal market share away from the giant. I remember watching an interview with the Microsoft CEO years ago and the reporter asked if he was concerned about the rise of Linux.

Linux what? He answered

I was surprised to see MSFT’s big boss not even consider that a competitor could hurt Windows’ market share. Today, I understand that there is not many competitors can do to battle with the “mother” of computers.

Business Segments

The company is simply divided into two segments:

Devices & Consumer

Here we find all products offered to “regular” consumers.It showed an 8% growth in revenue during the past quarter lead by sales of Office 365. I was also surprised to see how BING posted strong revenue growth (21%) in advertising income.

Commercial

s consumers we all know Microsoft, while MSFT makes the bulk of its income from its commercial segment (12.8 billion this quarter vs 9 billion from consumer segment). Revenue in this segment grew 5% this quarter lead by… the cloud business (+106%). The cloud business is definitely a great part of MSFT’s future. This is especially true when we consider that office suite sales declined during the last quarter. Many companies won’t update their software bundle as fast as MSFT will upgrade them.

Ratios

Price to Earnings: 20.14
Price to Free Cash Flow: 14.93
Price to Book: 4.36
Return on Equity: 22.25%

Revenue

MSFT Revenue

Revenue Graph from Ycharts

Similar to Apple’s revenue depending on how many iPhones versions it launches; Microsoft revenue growth is linked to how many software upgrades it can create. We can see that MSFT is not lazy when it’s time to provide new versions of their famous software. On top of that, MSFT diversified its revenue sources by investing massively in two other business sectors; game consoles with the Xbox and cloud services.

Earnings and Dividends

MSFT earnings and dividendsSource: Ychart

Earnings were temporarily hit by the Nokia adventure. While MSFT usually shows strong abilities investing in new businesses in order to generate growth, I’m not truly convinced it will be able to get something strong out of Nokia. Nonetheless, it seems MSFT doesn’t need Nokia to be profitable since its other businesses are doing well. I guess this is the benefit of being the world leader in software.

Approximate historical dividend yield at beginning of each year:

MSFT historical yield

 

 

 

 

 

As you can see, MSFT became very interesting as a dividend stock not so long ago. Prior to 2011, the yield wasn’t the most appealing. However, now the dividend is constantly increasing and the yield remains around 3%. Considering a relatively low payout ratio (under 50%), we can expect more dividend growth in the future.

How Does MSFT Spend Its Cash?

It’s funny to see a company that didn’t want to pay a dime in dividends a short while ago increase its dividend payment aggressively by 12.56% (annualized) over the past 5 years, right? During the last quarter alone, MSFT redistributed $7.5 billion to shareholders through share repurchases and dividend payments. The share repurchase program is authorized up to 40 billion dollars.

As any other techno companies, MSFT must invest massively into R&D. in 2014, the company spent 11.4 billion, an increase of 1 billion compared to 2013. Share repurchases and dividend payments are great, but I also like the fact MSFT is cautious about reinvesting massively into its operations. While MSFT focuses on improving existing products and services, they also spend lots of money on developing new innovation.

Investment Thesis

Microsoft finds another niche to dominate; here’s why the cloud business will push this giant higher. Both INTC and MSFT surged this year and even share a few points in common; strong demand for PCs in the market and their weakness to enter the mobile market. Microsoft also tried to “buy” its entry into the mobile market with the acquisition of Nokia. Now that they have announced a cut of 18,000 jobs (mainly in the Nokia division), we can wonder why it paid that much to acquire a cheap phone maker. Nonetheless, I prefer Microsoft over Intel for one reason; MSFT has found another niche to dominate with the cloud business. We all know the strength of Microsoft lies with all businesses using their services (Windows, Office series but also servers and business services). Since the cloud is the next big thing for most companies, Microsoft can expect huge growth from this segment in the future.

Risks

A few years ago, I wasn’t as confident in Microsoft’s future; the Xbox wasn’t doing that well, BING seemed like just another Yahoo! trying to compete with Google and Windows’ sales weren’t impressive. However, a few years later, BING generates revenues, Xbox is a strong player in the gaming industry and cloud services came out of nowhere with great growth potential. I guess this summarizes the risk you face while investing in a techno stock.

Overall, I think the risk is minimal since MSFT sits on strong and diversified sources of income. The software business will continue to generate strong cash flow while the growth will come from cloud services and other projects. Still, keep in mind that if MSFT wastes money like it did with Nokia, the future could turn rapidly into a nightmare.

Conclusion and Valuation

Using the historic price-earnings ratio will tell me how the market values MSFT over time:

MSFT PE ratio

My understanding of this graph is that MSFT is catching the attention of Mr. Market recently. The cloud business is a buzz word and it resonates throughout the MSFT valuation. Considering the company used to trade over a 22 multiple and as high as 27, the stock seems underpriced at the moment. Do we have a buy opportunity? The answer is probably yes… about a month ago! Let’s dig further.

Using the Discounted Cash Flow Analysis, we look at MSFT as a simple money making machine. The point is to assess the value of the company by considering its cash flow generation capacity. Considering the cash flow to continuously grow by 5% for the next five years and then by 4% and a discount rate of 10%, we have a stock trading at a 20% discount as the current company’s market value is at 392 billion.

MSFT Intrinsic Value 1

Then, by using the Dividend Discount Model, I keep the 10% discount rate and use a 10% dividend growth for 10 years (definitely supported by the cloud service growth and the upcoming delivery of Windows 10) and a 7% dividend growth rate afterward. Here’s what we get:

MSFT Intrinsic Value 2

According to this chart, the stock is trading at a 10% discount.

Overall, it seems that Microsoft is currently trading at a good price. The perfect time was definitely before its latest earnings report, but I’m fairly confident that the stock will continue to show strong results in the future.

Full Disclosure: As of this writing, I MSFT is part of our DSR Portfolios.

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Maiden Holdings – The Secret Small Cap with Strong Dividend Growth

Maiden Holdings Ltd (MHLD) is organized to provide, through an insurance subsidiary, property and casualty insurance and reinsurance business solutions mainly to small insurance companies and program underwriting agents in the United States and Europe. The company is based in Bermuda.

-Seven Year Revenue Growth Rate: 3.07% stock report
-Seven Year EPS Growth Rate: 5.98 %
-Seven Year Dividend Growth Rate: 18.70%
-Current Dividend Yield: 3.53%
-Balance Sheet Strength: Strong

Overview

MHLD is not the classic blue chip dividend payer you usually find in a dividend investor’s portfolio. The reinsurance business is a very stable business with predictable income. It’s a small cap with a low valuation (P/E around 15) and a reasonable yield (3.50%). This is probably one of the rare cheap opportunities on the market right now.

Founded in 2007, MHLD is born from what was previously the GMAC reinsurance platform. Most MHLD senior management are also former GMAC management team members.

This is not exactly the type of stock that shows up on my radar but it scored very high on my Dividend Stocks Rock Ranking and I thought about digging a little further.

Diversified Reinsurance

The company operates in two different segments: Diversified reinsurance and AM Trust Reinsurance.  The Diversified Reinsurance business consists of a portfolio of property and casualty reinsurance business focusing on regional and specialty property and casualty insurance companies located, primarily in the United States and Europe.

I’ll stop right here and provide you with additional information on what “reinsurance” means in the first place (definition coming from investorpedia):

“The practice of insurers transferring portions of risk portfolios to other parties by some form of agreement in order to reduce the likelihood of having to pay a large obligation resulting from an insurance claim. The intent of reinsurance is for an insurance company to reduce the risks associated with underwritten policies by spreading risks across alternative institutions.

Also known as “insurance for insurers” or “stop-loss insurance”.

Read more

Here’s how MHLD reinsurance products are split:

MHLD diversification

Ratios

Price to Earnings: 14.58
Price to Free Cash Flow: 1.55
Price to Book: 1.164
Return on Equity: 11.58%

Revenue

MHLD revenue

The revenues are keeping a steady and clear line headed skyward. However, one must remember the core business of MHLD is car reinsurance and the automobile industry has been doing very well over the past few years and MHLD obviously benefits from a good position and timing in its business.

Earnings and Dividends

MHLD earnings and div

I like the fact the dividend yield was relatively stable and the dividends paid keep increasing. Also, the payout ratio is relatively stable since 2013. This is quite a feat considering the important dividend payment increases since MHLD’s creation.

Approximate historical dividend yield at beginning of each year:

MHLD div yield

 

 

 

 

 

What catches my attention from the previous graph is how the dividend tripled in only 7 years. I know it’s impossible for the company to keep hiking its dividend at this rate, however, since the payout ratio has stayed relatively low, we could see other strong increases over the next few years.

How Does MHLD Spend Its Cash?

The company used some serious debts to buy GMAC RE back in 2007. Since then, MHLD’s focus was to repurchase this junior debt in order to reduce its cost of capital and eventually be able to give more to shareholders. Last year, the company repurchased all of the outstanding Trust Preferred Securities (the “TRUPS Offering”), with a face value of $152.5 million

In 2014, the board approved a 75 million budget for share repurchases while management keeps hiking dividend payments year after year since its creation.

Investment Thesis

MHLD is evolving in a relatively stable and predictable market. The company focuses on building strong partnerships with insurance companies that constantly require MHLD services to pursue their business.

The management team shows very strong experience with the previous GMAC RE background. The company continues to post solid results quarter after quarter and is well positioned to gain more business in Europe as MHLD provides solutions for new risk base regulations coming to Europe.

Therefore, we should see revenues continue to grow in the upcoming years.

Risks

There are possible conflicts of interest as MHLD’s founding shareholders own and control 53.9% of the outstanding shares of AM Trust Financial Services which is MHLD’s main client since 2008. There are also several short sellers around this stock due to these possible conflicts of interest. This is the reason why we will use a higher discount rate to value the stock

Conclusion and Valuation

The first step for stock valuation is to look at its historic P/E ratio to see how the market values MHLD.

MHLD PE ratio

There have been several ups and downs in the valuation. To be honest, I’m not a big fan of companies without a steady valuation. Could MHLD be worth as little as 7.5 times the earnings or as much as 26? This is hard to tell at the moment and I will use the Dividend Discount Model to give a better value to the stock.

Because MHLD has a client generating the bulk of its income and MHLD’s management controls this client, I will use a discounted rate of 12%. This is higher than my usual discount rate for a solid dividend stock. I usually consider a discount rate between 9 and 11%, but MHLD shows higher risk in my opinion. I use the two stages DDM calculation from The Dividend Toolkit as I think the dividend growth can continue increasing by 10% for the next 10 years but will reduced to 7% afterward.

MHLD intrinsic valueSource: Dividend Toolkit Calculation Table

As you can see, the stock is slightly over valued using these metrics. For someone who is willing to take additional risk in their portfolio, he will most likely be rewarded with this company as I was quite severe in my valuation. Still, I almost get to the current value.

In other words, if you have a strong portfolio including several blue chips, adding MHLD to your portfolio will probably be a good trade.

Full Disclosure: As of this writing, MHLD is part of our DSR Portfolios.

 

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Polaris Industries:  The King of Off-Road Recreational Vehicles

This article is a guest post written by Ben Reynolds of Sure Dividend.  Sure Dividend focuses on high-quality dividend growth stocks suitable for long-term holding.

You may not have heard of Polaris Industries (PII)  – it does not get as much recognition as other dividend growth stocks like McDonald’s (MCD) or Apple (AAPL).  Still, Polaris Industries is the industry leader in off-road vehicles.  Investing in the top company in an industry can produce phenomenal returns.  Case-in-point:  over the last 10 years, Polaris Industries has compounded its earnings-per-share at 16.8% a year.  The company’s share price has increased nearly 400% in the same time period.

With rapid growth, one would expect Polaris Industries to be a relatively new company.  It is not, however.  Polaris Industries was founded in 1954.  The company has paid steady or increasing dividends since 1989, making Polaris Industries a potential candidate to consider when building a dividend growth portfolio.  Polaris Industries’ operations, growth prospects, and dividend are analyzed below.

Business Overview

Polaris Industries Operations are split into 5 segments.  Each segment is shown below along with the percentage of total revenue generated by the segment for Polaris Industries in fiscal 2014:

  • Off-Road Vehicles: 65% of revenue
  • Parts/Garments/Accessories: 17% of revenue
  • Motorcycles: 8% of revenue
  • Snowmobiles: 7% of revenue
  • Small Vehicles: 3% of revenue

The Off-Road Vehicles segment is by far the largest.  The segments sells off road vehicles under the Ranger, RZR, Sportsman, and Ace brands.  Polaris Industries surpassed its competitors to become the market share leader in off-road vehicles in 2010.  Since that time, the company has increased its market share lead every year thanks to its strong brands.

The company’s second largest segment is the Parts/Garments/Accessories segment (hereafter referred to as PG&A).  The PG&A segment generated 53% of revenue from accessories, 39% from parts, and 8% from apparel in fiscal 2014.  69% of total revenue came from off-road vehicle PG&A items.

The company’s other 3 segments accounted for 18% of total revenues in 2014, combined.  The motorcycles segments sells under the Victory, Indian Motorcycles, and Slingshot brands.  The Snowmobiles segment sells the following brands:  RMK, Indy, Rush Pro Ride, and Switchback.  The Small Vehicles segments sells under the GEM, Groupil Industries, Aixam, and Mega brands.

Growth Analysis

Polaris Industries has experienced phenomenal growth over the last 10 years.  The company’s 10 year growth rates over a variety of metrics are shown below:

  • Revenues-Per-Share Growth Rate: 1% per year
  • Earnings-Per-Share Growth Rate: 8% per year
  • Dividends-Per-Share Growth Rate: 7% per year
  • Book-Value-Per-Share Growth Rate: 7% per year

As you can see, Polaris Industries has compounded shareholder wealth at between 12.7% and 16.8% a year over the last decade, depending on what measure you use.  The company’s rapid growth has been driven by finding the ‘right people’, focusing on quality, and building its brands while increasing efficiency.  Over the last decade, profit margins have increased from 7.7% to 10.1% – a significant boost in profitability.

Polaris’ management is expecting 12% sales growth per year and 13% earning-per-share growth per year up to the year 2020.  If the management of most companies announced 13% earnings-per-share growth goals to 2020, investors would be wise to be skeptical.  With Polaris Industries – the opposite is true.  It is very likely the company hits its 13% earnings-per-share growth goals up to 2020.  The company greatly exceeded this level of growth in earnings-per-share over the last decade.  It would take a significant and protracted recession for the company to not grow earnings-per-share at a 13%+ a year going forward.

Polaris Industries will achieve its growth as it gains greater efficiencies through scale.  The company is opening up a new manufacturing plant in the U.S. in the second quarter of 2016.  Additionally, Polaris Industries is seeing strong demand for both in both its Motorcycles segment and its flagship Off-Road Vehicles segment.

Dividend Analysis & Valuation

Polaris Industries currently has a dividend yield of 1.5% and a payout ratio of just 28%.  With a low payout ratio and a high expected growth rate, dividend investors in Polaris Industries should expect dividend growth of at least 13% a year over the next several years, and quite possibly higher.  By 2020, current investors will have a yield on cost around 3% if the company grows its dividend payments at 13% a year.  It is quite possible the company will grow its dividend payments significantly faster.  If management decides to increase its payout ratio over the next several years, dividend investors will see even higher yields-on-cost.

Polaris Industries currently offers shareholders an expected total return of 14.5%.  This return comes from dividends (1.5%) and expected earnings-per-share growth (13%).  With a total return of 14.5%, Polaris industries investors can expect to double their initial investment in just over 5 years.

Somewhat surprisingly given its strong growth history, Polaris Industries does not trade at a nose-bleed price-to-earnings ratio.  The company currently has a price-to-earnings ratio of 21.4 and a forward price-to-earnings ratio of 16.3.  At current prices, Polaris Industries appears fairly valued – if not undervalued – considering the company’s excellent growth prospects.

Dividend Monk’s Note:

I decided to use the Dividend Discount Model to add more on valuation in this article.

Using the Dividend Discount Model with a dividend growth of 13% for the first 10 years  and then a smaller dividend growth rate of 9% and a discount rate of 11% (since the company is not comparable to a giant dividend payer such as MCD), we get the following chart:

Calculated Intrinsic Value OUTPUT 15-Cell Matrix
Discount Rate (Horizontal)
Margin of Safety 10.00% 11.00% 12.00%
20% Premium $392.50 $193.86 $127.75
10% Premium $359.79 $177.70 $117.10
Intrinsic Value $327.08 $161.55 $106.46
10% Discount $294.37 $145.39 $95.81
20% Discount $261.67 $129.24 $85.17

The Dividend Toolkit provides me with a two stage DDM calculation and clearly shows the stock trading at a 10% discount. I’ve doubled check my valuation with Morning Star and they value PII at $169. Therefore, my calculation are line with other analysts.

Final Thoughts

Polaris Industries has grown to become the leader in the North American off-road vehicle industry.  The company has experienced somewhat of a renaissance over the last decade – and especially the last 5 years.  Management has done a fantastic job of growing the business while simultaneously increasing margins and paying dividends.

In addition, Polaris Industries scores high marks for safety.  The company is a member of the Dividend Achievers Index; it has increased its dividends each year since 1992 and has paid steady or increasing dividends since 1989.  Polaris Industries has just under $230 million in debt on its books.  The company made $455 million in profits in 2014; Polaris Industries is conservatively financed.  In addition, the company has over $100 million in cash on hand.

Polaris Industries is a conservatively financed industry leader .  The company offers investors solid dividend growth potential with a current yield about 0.3 percentage points below the S&P 500’s current dividend yield.  Polaris Industries shares may be suitable for long-term dividend growth investors focused more on future income than current income.

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