Dividend Monk

Summary

• GM has greatly improved its financial health and is back on “growth mode”.
• GM has eyes on the future to fuel its growth (electric & autonomous car).
• There are several clouds looming (competition, high debts, underfunded pension plans).

Are you ready to give it a second chance? This is often a question investors must ask themselves when they look at a company that already cut their dividend. Did management really understand what put them there in the first place? While General Motors (GM) has done a marvelous job at getting back from the dead, I’m not sure it can be qualified as a “safe dividend payer” yet. GM was once admired by many as the world’s #1 automotive constructor. After its fall in 2008-2009, the company worked very hard to bring its iconic brand to the top. It did a great job, but is it enough?

Understanding the Business

General Motors doesn’t need a presentation. Even my 6-year-old can tell the difference between a GM and a Ford since there are so many of their cars on the market. GM is not only a leader in the automotive industry, it is also a leader in the high-margin pickup truck sub-segment.

GM’s presentation

GM is obviously tied to the car industry and its cycles. After becoming a low leaner, it is now showing a breakeven point when production reaches around 10-11 million units. The company counts on less brands and more productive processes. GM has switched from an old model where it used to overproduce some models and shove them through consumers’ throats to a business model where it produces what clients want and meets the demand instead of exceeding it.

Growth Vectors

Source: Ycharts

GM counts on its leadership in the pickup truck segment to boost its cash flow in the upcoming year. The demand for such vehicles remains robust and offers growth possibilities for the years to come. It seems that everybody wants to drive a pickup these days! China and other emerging markets are obviously stable a growth vector for the automotive constructor.

Now that the company is back on track with stronger financial results, it has an eye on the future. This is a future with electric and autonomous cars. Two very intriguing, yet promising segments.

Source: GM’s investors presentation

As the population grows and move toward urban areas, the desire of driving their Corvette with their hair in the wind, is being replaced by low gas consumption transportation. Even better, if people can start working early in their car and don’t have to mind traffic while commuting to work, they’ll go for an autonomous electric car. This was pure Sci-fi a few years ago, but now we have a feeling that GM could possibly be among the pioneer in this sector.

Source: Ycharts

GM has made gigantic steps in improving their cash flow generation abilities. As a dividend investor, I’m also pleased to see that management used $25B for its shares repurchase program (GM bought back 25% of outstanding shares) along with its dividend payments. Speaking of which…

Dividend Growth Perspective

GM reinstated its dividend payment in 2014 and has increased it twice since then. We are not talking about a super-powered dividend grower. To be honest, there are tons of Dividend Achievers I prefer before picking GM. You can get the full list here.

Source: Ycharts

At a 3.5%-4% dividend yield, GM could please income seeking investors such as retirees. GM dividend brings back good old memories spent of summer vacation in an Oldsmobile. However, we are far from driving on that highway right now.

Source: Ycharts

As previously mentioned, GM has seriously improved its cashflow generation abilities and that shows through its cash payout ratio. Before the tax bill changes short term EPS, GM’s payout ratio was also well under control. While GM tries to seduce investors with shares buyback programs and juicy dividend, I expect low-single digit growth for the future. As you are going to see in a moment, GM has other cash flow priorities.

Potential Downsides

GM obviously counts on its strong reputation and brand awareness to sell more cars. However, I doubt this will be enough going forward. The competition is fierce, and consumers are already loaded with car debts. There is a limit in refinancing their old car with a new one.

Developing, manufacturing and marketing cars is a capital-intensive business. It becomes even more expensive when you are going outside the box and go with new technology (electric/autonomous). While GM’s cash flow from operation is skyrocketing, its debts are also raising fast.

Source: Ycharts

Such high debt will need to be paid at one point in time. As long as the global demand for cars remains stable, this is not a problem. However, an economic downturn could quickly get GM back on its heels. Don’t be too quick to forget about 2008 disaster. GM is not out of the woods yet.

Finally, GM is still dragging substantial pension funds expenses. In their Q4 2017, the company estimated its pension funds underfunded debt to be around $14 billion. This is not pocket change.

GM Q4 2017

Valuation

Assessing the value of a company that went through so much over the past decade is quite a challenge. In fact, the problem is that there are absolutely no trends here:

Source: Ycharts

The PE valuation is completely useless as GM went up and down and completely transformed its business over the past 10 years. Now, using the Dividend Discount Model is also a big guess as we have limited dividend history and lots of assumptions to take into consideration.

Input Descriptions for 15-Cell Matrix				INPUTS
Enter Recent Annual Dividend Payment:				$1.52
Enter Expected Dividend Growth Rate Years 1-10:				3.00%
Enter Expected Terminal Dividend Growth Rate:				3.00%
Enter Discount Rate:				10.00%
	Discount Rate (Horizontal)
Margin of Safety	9.00%	10.00%	11.00%
20% Premium	$31.31	$26.84	$23.48
10% Premium	$28.70	$24.60	$21.53
Intrinsic Value	$26.09	$22.37	$19.57
10% Discount	$23.48	$20.13	$17.61
20% Discount	$20.87	$17.89	$15.66

Please read the Dividend Discount Model limitations to fully understand my calculations.

Since GM hasn’t increase its payouts since 2016, I can’t go crazy with the dividend growth rates. I decided to stick to 3% going forward. I also used a 10% discount model mainly because GM could fact many headwinds going forward.

Final Thought

I don’t think GM shares will fall by 40% this year. However, the DDM calculations show me there is no deal in buying GM today. That’s too bad because I like that the company is going toward electric cars. I really hope they succeed as a consumer, but I’ll pass as an investor.

Disclaimer: I do not hold GM in my DividendStocksRock portfolios.

Summary

• PC sales are sluggish? Microsoft just moved towards the cloud at fast pace.
• MSFT strong relationships with Corporate America will help the company integrate many other services.
• The tech giant successfully switch from a one time software sale to a subscription based product with Office 365.

Microsoft (MSFT) has polarized investors for a while now. On one side, bears are telling the world that PC sales are going nowhere. Bears even come up with this theory that the PC era is dead and it will bring MSFT in its hole. I can’t argue with PC sluggish sales, bears are right on this point:

Source: Statista

Nonetheless, I disagree with their investment thesis. Microsoft is a resourceful company and saw PC sales headwinds coming at them a while ago. Over the past few years, it has moved its one time software sales approached towards subscriptions based with the creation of Office 365 (sales were up +41% during the latest quarter). It built a strong cloud environment climbing to #2 in the public business and integrating multiple solutions for businesses. I think Microsoft shares will easily hit the $100 mark, here’s why.

Understanding the Business

First, repeat after me: Microsoft isn’t just Windows and Office anymore. While the company has been tied to PC sales decades, this business model is dead already. Microsoft is the worldwide leader in software, services, devices and solutions helping consumers and businesses to become more productive. The company operates under 3 segments.

Source: author’s table based on Q2 2018 results

More Personal Computing (+2% Q2 2018) is still MSFT’s largest business segment with 42% of its revenue. This is probably why investors still think this tech giant is all about PC sales. This segment shows modest growth, but gaming revenue is showing a steady uptrend (+8%) with its Xbox live platform.

Productivity and Business Processes (+25% Q2 2018) is Microsoft’s second largest division. It includes its Office 365 service that is now based on a subscription model. LinkedIn results are also included within this segment.

Intelligent Cloud (+15%  Q2 2018) may be the smaller units in MSFT, but it shows a strong potential. Public and corporate cloud services are growing at a fast pace. Azure shows 10 consecutive quarters with 90%+ growth.

Growth Vector

Source: Ycharts

Microsoft counts several growth vectors to ensure its future growth. First, the cloud business growth will last for a decade. MSFT currently shows over 800 case studies of cloud services provided to corporate clients on its website. Its strong bond with its clients is the reason why Microsoft came as a natural choice for businesses and governments when it’s time to move toward cloud based solutions for their operations. In the public space, Amazon (AMZN) remains the leader in this business and proved this business as highly profitable. Microsoft is a solid #2 with Azure showing nearly 3 years of impressive growth.

Second, MSFT is pushing its relationship with Corporate America to a whole new level. MSFT has never been afraid to deploy money to find additional growth vectors. It acquired several companies like Skype and LinkedIn. MSFT also developed its own applications including Teams (MSFT response to Slack, a cloud based workspace for businesses). Now, MSFT shows the most complete offer to businesses who want to improve their productivity. This “all-in-one” offer positions MSFT as a natural choice if you want to reach the next step with your business.

Third, subscription based solutions will drive increasing cash flow in the upcoming years. There was once a time where Windows & Office versions were the only way MSFT could push its revenue up. It was constantly working on a software cycle trying to convince clients to upgrade their system on a constant basis. Now that MSFT has shifted toward Office 365, clients will just keep paying their subscription and benefit from future upgrades. This makes cash flow more predictable and should boost margins along the way.

Dividend Growth Perspective

Microsoft shows 14 years of consecutive dividend increases. This makes it part of the elite Dividend Achievers list. The Dividend Achievers Index refers to all public companies that have successfully increased their dividend payments for at least ten consecutive years. At the time of writing this article, there were 265 companies that achieved this milestone. You can get the complete list of Dividend Achievers with comprehensive metrics here.

Source: Ycharts

I’ll agree with you, MSFT yield has lost its appeal now that it is lower than the 2% mark. But take a second to look at the blue line on the graph to see how fast MSFT price grew since 2016. Even if its dividend jumped by 82.61% over the past 5 years, it wasn’t enough to keep the yield at its 2.50%-3% levels. This means one thing; Microsoft is back on strong growth mode.

Source: Ycharts

MSFT payout ratio seems through the roof after its latest quarter but that was just related to a $13.8 billion net charge related to the Tax Cuts and Jobs Act. If you look at the cash payout ratio, you will notice that it is not only low (37%), but that it has been decreasing for the past 12 months. The effect of subscription based solutions is starting to show.

MSFT shareholders can expect a high single-digit dividend growth rate for several years to come. I wouldn’t be surprised to see MSFT showing a 9% dividend CAGR for the next decade.

Potential Downsides

The fact that PC sales are going down in the upcoming decade will not help MSFT. But instead of dragging MSFT results in negative territories, I think it will have a modest impact as the company grows in other sectors.

While MSFT is currently spending its money well, management made several bad acquisitions throughout its history. I guess that having so much money in hands could be dangerous sometimes. Let’s hope MSFT will continue to use its money wisely instead of buying another Nokia…

Valuation

When I bought shares of MSFT at $75 before its Q1 2018, many were saying that it was overpriced. Since then, the stock surged to $90+. Maybe it is overpriced now?

Source: Ycharts

MSFT 12 months forward PE ratio is at 25.61. While this number alone seems relatively high, I think it’s the right price to pay for such a leader with many growth avenues.

Going deeper, I used the dividend discount model to see how much MSFT should be trading at. I was pleasantly surprised to find significant value in MSFT.

Input Descriptions for 15-Cell Matrix				INPUTS
Enter Recent Annual Dividend Payment:				$1.68
Enter Expected Dividend Growth Rate Years 1-10:				9.00%
Enter Expected Terminal Dividend Growth Rate:				7.00%
Enter Discount Rate:				9.00%
Margin of Safety	8.00%	9.00%	10.00%
20% Premium	$257.75	$128.02	$84.81
10% Premium	$236.27	$117.35	$77.74
Intrinsic Value	$214.80	$106.68	$70.67
10% Discount	$193.32	$96.01	$63.61
20% Discount	$171.84	$85.34	$56.54

Please read the Dividend Discount Model limitations to fully understand my calculations.

With a stock trading around $90, there is roughly a 15% immediate upside. You may think that a 9% and 7% dividend CAGR is generous, but keep in mind that Microsoft has increased its payout by 282% over the past 10 years for a CAGR of 14.34% and still shows a cash payout ratio under 40%. Therefore, expecting a high single-digit dividend growth rate is justifiable.  MSFT will hit $100 in no time.

Final Thought

Don’t let bears tell you what to do. While the market is currently volatile, there is one thing I’m sure; Microsoft will be thriving in the next 10 years and I certainly don’t want to miss the growth. MSFT shows a great combination of steady cash flow generation and growth vectors insuring years of joy for shareholders.

Disclaimer: I do hold MSFT in my DividendStocksRock portfolios.