Human nature is extremely fascinating and puzzling. We continually read/hear about investors taking positions in publicly-listed companies of dubious quality. In some cases, these companies are outright frauds. Nevertheless, some people are willing to speculate in such companies without fully comprehending the risks.

At the other end of the spectrum, we have Microsoft Corporation (MSFT). The stock is one of Dividend Power’s best dividend growth stocks.

If an investor has a low risk tolerance then MSFT’s AAA credit rating will be appealing. In fact, MSFT and Johnson & Johnson are the only two remaining AAA-rated companies. This is down from ~60 in the early 1980s and ~15 in 2000; after the turn of the century, companies such as Automatic Data Processing, Exxon Mobil, UPS, Berkshire Hathaway, General Electric, Pfizer, Toyota and others were downgraded.

Some analysts claim that corporate buyouts and acquisitions accelerated the trend toward rating downgrades. Companies lost their AAA rating because when they were taken over, their new owners loaded them with cheap debt to help pay for the acquisition.

In UPS’s case, for example, the reason is somewhat different. It lost its AAA rating after the company negotiated a long-term agreement with its unionized employees that raised pay and benefits but froze certain pension obligations. Shortly after the negotiation of this long-term agreement, the rating agencies started lowering UPS’s credit rating; Moody’s downgraded UPS two notches to Aa2 in December 2007. Subsequent downgrades have occurred over the years and UPS is now an A2 rated company. This is still an investment-grade rating but it demonstrates that maintaining the best possible credit rating was not UPS’s priority.

Despite the downgrades, investors have generally shrugged off the changes; the markets anticipate these downgrades and the rating agencies are ‘late to the party’.

Microsoft – ‘AAA’ Dividend Safety – Overview

Most are undoubtedly familiar with MSFT to some extent and its three segments:

• Productivity and Business Processes;
• Intelligent Cloud; and
• More Personal Computing.

A good overview of each segment is found within Part 1 Item 1 – Business in MSFT’s FY2021 10-K. This section also includes a brief overview of MSFT’s competition in each segment and a review of the company’s key risks.

The following is MSFT’s FY2019 – FY2021 segment revenue and operating income.

Source: MSFT – FY2021 Form 10-K

The FY2019 – FY2021 revenue from external customers, classified by significant product and service offerings, is as follows:

Source: MSFT – FY2021 Form 10-K

The following graph reflects the quarterly performance of each operating segment dating back to Q1 2016. We see that the growth in the Intelligent Cloud segment has outpaced that of the other 2 segments.

Microsoft – ‘AAA’ Dividend Safety – Financial Results

Details of MSFT’s Q1 earnings released on October 26, 2021 are accessible here.

The following financial highlights provide a quick overview of MSFT’s Q1 2002 performance.

Source: MSFT – Q1 2022 Earnings Presentation – October 26, 2021

Source: MSFT – Q1 2022 Earnings Presentation – October 26, 2021

Net Cash From Operations and Free Cash Flow

In FY2012 – FY2021, MSFT generated FCF (in billions of $) 29, 25, 27, 24, 25, 31, 32, 38, 45, and 56.

In Q1 of FY2021 and FY2022, MSFT generated the following:

Source: MSFT – Q1 2022 Earnings Presentation – October 26, 2021

In reviewing the historical cash flow statements for the past decade, it is evident MSFT consistently generates strong cash flow. This cash flow can be retained to fund growth (acquisition and organic), repurchase shares, and/or increase dividends.

Microsoft – Financial Guidance

When MSFT released FY2021 results on July 27, 2021, FY2022 guidance was:

• FY2022 double-digit revenue and operating income growth;
• Cost of Goods Sold: $13.55B – $13.75B;
• Operating Expenses: $11.6B – $11.7B;
• Offsetting other income and expense and interest income and expense;
• Q1 tax rate: ~16%;

On October 26, 2021, MSFT provided the following update to its guidance:

• FY2022 double-digit revenue and operating income growth;
• Cost of Goods Sold: $17B – $17.2B;
• Operating Expenses: $12.7B – $12.8B;
• Offsetting other income and expense and interest income and expense;
• Q2 tax rate: ~17%.

Microsoft – ‘AAA’ Dividend Safety – Credit Ratings

In my September 7, 2021 JNJ post, I state that JNJ’s total investment return potential may fall short of what can be generated elsewhere. JNJ’s appeal, however, is its safety.

The same applies to an investment in MSFT.

Moody’s, S&P Global, and Fitch all assign a AAA rating with a stable outlook.

This rating defines MSFT as having an EXTREMELY STRONG capacity to meet its financial commitments.

Microsoft – ‘AAA’ Dividend Safety – Dividends and Share Repurchases

Dividends, Dividend Yield and Share Repurchases

MSFT’s dividend history is found here. The company’s dividend growth for the past decade is seen below in the chart from Portfolio Insight*. The company has maintained a double-digit dividend growth rate for the past 5-years and 10-years. The stock is a Dividend Contender and will likely become a Dividend Aristocrat.

(Click on image to enlarge)

Source: Portfolio Insight*

MSFT has a user-friendly section entitled ‘Cash Returned to Shareholders‘ from which investors can review the following over different timeframes:

• Dividends per Share;
• Total Dividends; and
• Share Buybacks

On September 14, 2021, MSFT announced that its Board of Directors declared a $0.62/share quarterly dividend payable December 9, 2021 to shareholders of record on November 18, 2021. This $06/share/quarter dividend increase is ~10.7% higher than the previous quarter’s dividend.

With shares currently trading at ~$336.50, the forward dividend yield is ~0.07%.

MSFT is a prolific buyer of its shares. The weighted average diluted outstanding shares in FY2012 – FY2021 (in millions of shares) is 8,506, 8,470, 8,399, 8,254, 8,013, 7,832, 7,794, 7,753, 7,683, and 7,608. At the end of Q1 2022 (September 30, 2021) this had been further reduced to 7,567.

MSFT – Shares Repurchased Quarterly in FY2019 – FY2021

In Q1 2022, MSFT repurchased 21 million shares totalling $6.2B.

Looking at the Statement of Cash Flows in the Q1 10-Q, we see MSFT issued $0.612B of common shares and incurred $1.702B in stock-based compensation expense.

The Board of Directors has also recently approved a new share repurchase program authorizing up to $60B in share repurchases. The new share repurchase program, which has no expiration date, may be terminated at any time.

Microsoft – ‘AAA’ Dividend Safety – Current Valuation

The following earnings estimates are derived from the 2 online trading platforms I use. There is a significant disparity in estimates and this is likely because some brokers are in the midst of revising their estimates; I expect the disparity will narrow over the coming days. For now, however, MSFT’s forward adjusted diluted PE valuations based on the current ~$336.50 share price are:

• FY2022: mean of $9.20 and a low/high range of $8.85 – $9.70 from 22 brokers. The forward adjusted diluted PE using the mean estimate is ~36.5 and ~34.7 if I use $9.70.
• FY2023: mean of $10.51 and a low/high range of $9.87 – $11.43 from 32 brokers. The forward adjusted diluted PE using the mean estimate is ~32 and ~29 if I use $11.43.
• FY2024: mean of $12.57 and a low/high range of $11.45 – $13.74 from 13 brokers. The forward adjusted diluted PE using the mean estimate is ~26.8 and ~24.5 if I use $13.74.

The brokers’ earnings estimates reflected on the online trading platforms have been changing almost daily after the release of MSFT’s Q1 results as brokers update their revised estimates. As additional guidance is provided, I think the low end of earnings estimates will increase. This would lower the forward adjusted diluted PE levels thereby making shares more attractively valued.

Microsoft – ‘AAA’ Dividend Safety – Return on Invested Capital (ROIC %)

ROIC % measures how well a company generates cash flow relative to the capital it has invested in the business.

In FY2012 – FY2020 MSFT’s return on invested capital was 23.25%, 25.7%, 21.79%, 11.16%, 14.81%, 16.36%, 11.49%, 22.69%, and 23.9%.

MSFT’s current ROIC is ~36%. It generates higher returns on investment than it costs to raise the capital needed for investment purposes. If it continues to generate positive excess returns on new investments, we can expect MSFT’s value to increase.

Microsoft – ‘AAA’ Dividend Safety – Final Thoughts

Although MSFT holds the coveted AAA rating, it is ‘no big deal’. Many other high-quality companies have investment-grade ratings below AAA and they can negotiate attractive credit terms and conditions.

In reviewing the financial statements for multiple companies, I have noticed ‘High Grade’ or ‘Upper Medium Grade’ investment-grade companies have been able to negotiate very favourable terms in the current low-interest-rate environment. In many cases, some of these companies have had no change in their credit rating but they have been able to negotiate new debt at lower rates and maturity dates further out on the calendar and have used the proceeds raised to retire higher interest debt before maturity.

While I hold MSFT shares in a ‘Core’ account and a ‘Side’ account in the FFJ Portfolio, my decision to invest in the company is not based on the AAA credit rating. I choose to invest in MSFT because I like the company’s long-term prospects.

Regrettably, MSFT’s current valuation leaves little margin for error but I still view MSFT as a ‘BUY’. Should MSFT’s share price valuation become more attractive I would most definitely consider significantly increasing my exposure.