Dividend growth investing is one of the most powerful ways of compounding both income and wealth over time. But the universe of income investing is vast and not limited to stodgy slow growing companies and industry.
Cloud computing is one of the hottest growth industries right now and expected to remain so for the foreseeable future.
Analyst firm Gartner forecasts that from 2017 to 2021 the global cloud computing market will grow nearly 18% CAGR, or more than four times as fast as the global economy.
Synergy Research estimates the cloud computing market is already $250 billion in size, and growing even faster, 32% in 2018, with parts of the industry posting 50% sales growth.
So it's no surprise that tech giants are racing to lock in market share in this large, high margin and rapidly growing business. But unless you're Warren Buffett, you have limited funds to invest, and most people want to keep their portfolio to a manageable number of companies. This means income growth investors need to be selective with what cloud computing stocks they buy.
So let's take a look at two popular dividend cloud companies, Microsoft (MSFT) and IBM (IBM), who are some of the biggest players in cloud computing. Specifically, see how they compare in the six most important categories dividend investors care about.
Most importantly, learn why Microsoft has IBM beat, hands down, as the far better cloud computing dividend growth stock, even considering valuation. In fact, I expect Microsoft to deliver about double IBM's total returns over the coming five years.
Since dividend growth investing is all about income, let's start by looking at how each company's dividend profile stacks up, starting with long-term growth records.
Since IBM has been paying dividends for much longer, initially you might think it has the edge. After all, it's very close to becoming a dividend aristocrat, while Microsoft won't achieve that status for another 16 years.
And in terms of dividend growth rates, IBM at first seems to measure up well to Microsoft, at least over the past 20 years. But note that IBM's dividend growth has been slowing down over time, while Microsoft's has remained stable (9.5% hike for 2019).
That fast payout growth from MSFT is courtesy of a vastly superior business model and growth trajectory (more on this later). But dividend growth rates and track records are just two parts of the dividend profile, safety is by far the most important.
|Company||Yield||TTM FCF Payout Ratio|
Simple Safe Dividends Safety Score (Out Of 100)
|Microsoft||1.6%||42%||98 (Very Safe)|
While IBM may offer three times the yield, Microsoft has one of the safest dividends on Wall Street. That's not just due to a slightly lower payout ratio, but a far superior balance sheet.
|Company||Net Debt/EBITDA||Interest Coverage Ratio||S&P Credit Rating|
Average Interest Cost
|Safe Limit||3 Or Less||8 Or More||BBB- Or Better||NA|
Microsoft actually has $53.7 billion more cash than debt and only has higher borrowing costs because it mostly sticks to selling US bonds, while IBM is more active in overseas bonds where rates are much lower. But note that Microsoft is just one of two companies with a AAA credit rating (JNJ is the other) which is higher than the US Treasury's.
And we can't forget that IBM is going to take on a lot of debt to fund its $34 billion acquisition of Red Hat (RHT). This purchase (the largest software company acquisition in US history) is part of IBM's latest efforts to turn around its struggling business. Here's what Virginia Rometty (CEO since 2012) said regarding the strategic rationale for the purchase.
“The acquisition of Red Hat is a game-changer. It changes everything about the cloud market...IBM will become the world’s #1 hybrid cloud provider." - Virginia Rometty (emphasis added)
But while it's true that Red Hat is a potentially smart and bold move for IBM, according to the Harvard Business Review about 80% of M&A fails to deliver long-term shareholder value. That's especially true if a company overpays and IBM is paying a 63% premium for RHT. 10 and 30 times sales and free cash flow is a rich price to pay that means IBM has little margin of error when it comes to executing on its integration and growth plans for its future hybrid cloud business (and its track record on overall execution is poor).
But the large amount of debt IBM is taking on is a certainty, and S&P has already downgraded its credit rating from A+ to A over the far more bloated balance sheet.
Moody's has put IBM's credit rating on watch for a downgrade citing:
"a substantial increase in leverage... and a departure from IBM's historical acquisition philosophy of making small, tuck-in acquisitions that limit integration risk." - Moody's (emphasis added)
IBM will effectively be doubling its leverage ratio (debt/EBITDA) putting it above the 3.0 that's considered safe for most companies. As a result, IBM has said it will suspend buybacks for 2020 and 2021 to focus on deleveraging, but that will almost certainly mean even slower dividend growth in the years ahead.
And we can't forget that doubling leverage this late in the economic cycle also carries its own risks. Bond yields, even for investment-grade debt, can be highly volatile, spiking during times of financial market fear (as occurs in corrections and bear markets).
With a recession possibly coming in 2020 or 2021, IBM might find itself facing tighter credit markets and higher refinancing costs that means it needs to execute flawlessly on its plan to return to about a 1.7 leverage ratio by the end of 2021.
Even more impressive than Microsoft's already large cloud revenue is the fact that it continues to grow that business at a breakneck pace and gain market share.
That's at the expense of IBM, who has steadily been losing market share to larger, better funded, and nimbler giants like Amazon (AMZN), Alphabet (GOOG) and Alibaba (BABA). This explains Microsoft's far more impressive growth profile, both in terms of its top and bottom line.
Microsoft Growth Profile
Since Satya Nadella took over as CEO of Microsoft from Steve Ballmer in 2014, the company's cloud and mobile first strategies have seen it return to solid revenue growth.
That includes impressive growth in its most recent quarter of
Cloud revenue grew 20%, fueled by 76% growth in Azure (92% full-year growth), Microsoft's cloud platform. Even more impressive is that commercial cloud (48% YOY growth) gross margins increased 5% to 62% over the past year, showing that Microsoft's overall cloud ecosystem is benefitting from ever larger economies of scale and rising network effects.
Basically, cloud computing isn't just about data storage for companies. The ultimate winners in the industry will be companies that can combine data storage with advanced AI-based software and data analytics offerings that help customers maximize efficiency and profits.
Microsoft's one-stop shop in terms of productivity software, which is deeply integrated into Azure (as is LinkedIn now), is the main reason Microsoft is able to achieve some of the industry's fastest growth rates while continuing to enjoy strong pricing power (wide moat).
IBM Growth Profile
In contrast, IBM has struggled with declining or flat sales since 2012, when it began its latest major corporate turnaround effort. That involves selling declining legacy hardware businesses and focusing on strategic imperatives or SI, which includes analytics, cloud computing, security, and mobile. Basically, SI is the future tech divisions IBM hopes to fuel its eventual return to high single-digit earnings and free cash flow growth.
However, while the street may have liked IBM's most recent results (the benefit of very low expectations) the company still reported a 3% decline in revenue (-1% in constant currency).
And none of its business segment posted impressive growth, including cognitive solutions, which is home to IBM's much-hyped Watson AI platform. The huge decline in systems was caused by the launch of the Z-mainframe rolling off its comps and shows that IBM's brief 2018 return to positive top-line growth was not a trend reversal, but a temporary occurrence.
In fairness to IBM, SI did make up 53% of revenue in Q4 and 50% in 2018, which is a goal the company has spent years trying to reach. And in absolute terms, SI is growing strongly.
However, it should be pointed out that IBM has been suffering from steadily falling growth rates in SI and this is the collection of businesses that are supposed to return it to modest top-line growth in the future. Thus far they've been unable to accomplish that and with IBM losing market share in cloud, that slowing growth could continue, causing IBM to deliver bottom-line growth that's far below what management is guiding for over the long-term.
In fact, according to FactSet Research analysts don't think current management can deliver anywhere close to high single-digit EPS growth, but just 2.3% CAGR over the next five years (with sub 2% growth through 2020). Morningstar's 6.1% earnings growth forecast is the most bullish I've seen for the company, yet also has the company falling far short of its guidance.
And those growth estimates now include Redhat, which is a very fast growing and cash-rich company (over 30% FCF margins).
IBM says that Redhat will accelerate top-line growth 2% over the long-term, which would be a welcome relief for investors who have sales fall or stagnate for seven straight years.
IBM claims that the deal will be accretive to cash flow within one year which is important since free cash flow is what funds dividends and pays down debt. However, due to high integration expenses, IBM is now guiding for a double-digit decrease in FCF for 2019.
This continues a decade long trend of flat FCF/share, which explains why IBM's dividend growth has slowed over time. And given the need to deleverage ASAP to retain a strong credit rating and good financial flexibility in the future, income investors can likely expect even slower payout growth through at least 2021 if not longer.
In contrast, Microsoft's FCF/share growth, while far from the best in the industry, is at least trending higher over time.
And keep in mind that a big reason that Microsoft's FCF is up just 26% since Nadella took over is Microsoft's much higher spending on R&D and capex to accelerate its cloud growth.
What about IBM? Well, it too spends a lot on R&D, but far less than Microsoft, or its large cloud peers.
And most importantly, IBM's investments over time have failed to deliver strong returns on investment, which brings me to the most important reason that Microsoft is a far better investment.
The quality of a business, including management's capital allocation skills, is the most important driver of long-term total returns. A good proxy for business and management quality is a company's profitability metrics.
|Company||Operating Margin||FCF Margin||Return On Equity|
Return On Invested Capital
|Good Company Benchmark||12%||5%||10%||8%|
Microsoft's margins are vastly superior to IBM's and the only reason IBM has higher returns on equity is the much more leveraged balance sheet. And while MSFT and IBM have basically equal returns on invested capital today, the long-term trend of that management quality proxy is what matters most.
IBM ROIC Over Time
Since Rometty took over in 2012, IBM's ROIC has fallen by over 50%. In fairness, it has bounced back a bit from its 2017 lows, BUT the very expensive RHT acquisition is likely to send it plummetting to fresh 10+ year lows.
In contrast, Nadella's tenure at MSFT has also turned around a long slide in ROIC that was due to Ballmer's complacency and horrific acquisition strategy. Nadella is the one who moved Microsoft from a perpetual license model focused on Windows to a subscription-based software as a service model deeply integrated into the cloud. He also quit the incredibly competitive and no margin wireless handset business that Ballmer failed to compete in. Morningstar's Dan Romanoff considers Nadella an "exemplary" CEO and I agree wholeheartedly.
Microsoft ROIC Over Time
It should be noted that the LinkedIn acquisition is a big reason that MSFT's ROIC dipped in 2017 but it's since bounced back nicely, due to the success that deal has proven to be.
Microsoft's 2016 $26.2 billion acquisition of LinkedIn was highly controversial at the time, with many feeling it harkened back to Steve Ballmer's famous penchant for lighting shareholder money on fire by vastly overpaying resulting in huge write-downs later.
But as you can see above, LinkedIn revenue is growing consistently at 30+% YOY thanks to similar growth rates in participation. Basically, Nadella bought LinkedIn to strengthen the cloud ecosystem by enhancing productivity-boosting features, which is helping to drive strong growth in commercial subscribers to Office 365. In fact, 89% of Microsoft's commercial software business is now subscriber based, creating annuity-like recurring monthly revenue.
The most recent big acquisition Microsoft made was the 2018 $7.5 billion stock-based purchase of Github. Github is the "Facebook of programmers" with 31 million accounts and 100 million codes stored in its cloud-based servers. Those programs serve over 1.5 million companies and organizations around the world and Microsoft hopes that those programmers will become addicted to the Azure-based platform that Github under MSFT ownership will provide.
And while IBM is making what's likely a desperate and overpriced and debt-funded acquisition to strengthen its cloud position, Microsoft is making far less risky moves such as partnering with VMWare (VMW), Accenture (ACN), and Mastercard (MA) to offer ever improved services to its customers. Which is why it keeps landing big clients like Exxon (XOM) to host its cloud needs. In fact, Microsoft's cloud business, which at 48% is growing more than twice as fast as IBM's, is now hosting over 420,000 global companies and organizations. That includes 89% of the Fortune 100.
What about IBM's big investments? Well, the difference between IBM and Microsoft's overall investment approach can be summed up like this. IBM mints patents, while Microsoft mints money.
Watson is a great example of this, with IBM having spent billions on the AI platform over the years and hyping it to the moon via famous appearances on Jeopardy, and Superbowl commercials touting it as "one of the most powerful tools our species has created."
Virginia Rometty has also spent years proclaiming that Watson was a game-changing differentiator for IBM that is "touching a billion people... and be able to address, diagnose, and treat 80 percent of cancer in the world."
In fact, Rometty is famous for overpromising and under delivering. When she took over in 2012 and began IBM's now seven-year turnaround effort she guided for $20 per share in Adjusted EPS in 2015. IBM missed that target by 26% ($14.90) and adjusted EPS fell to $13.8 in 2017 and 2018 and now management is guiding for "at least $13.8" in 2019 (but with 10% less FCF).
Essentially Watson has, like most of IBM's big R&D efforts and Rometty's promises, failed to deliver top or bottom line growth over time. For example, IBM's Cognitive Solutions segment, home of Watson, saw very little growth in the past quarter, despite the supposed world-changing power of that AI platform.
What's more, margins actually fell, showing that Watson based SI and cloud offerings don't have strong pricing power, unlike Microsoft, where cloud margins are soaring year after year.
This highlights my biggest issue with IBM in general, which is that management likes to use the hottest buzzwords, and file lots of patents for promising future tech, yet investors never seem to benefit.
In 2018 IBM's army of 8,500 researchers, engineers, scientists, and designers in 47 different U.S. states and 48 countries were granted a record 9,100 patents, the 26th consecutive year in which IBM received the most corporate patents in America.
Over 5,000 of those patents were in "hot" industries like AI, cloud, and cybersecurity. The company is also getting patents for quantum computing, healthcare, and blockchain. From 1993 to 2018 IBM obtained over 110,000 patents which should make it a dominant name in every industry in which it operates and set it up for a glorious Star Trek-like future.
Yet one of the largest collections of patents on earth hasn't stopped IBM investors from losing money during Rometty's tenure, even factoring in dividends.
While the market can, and often is wrong about a company's value in the short-term, over the long-term total returns are always a function of good management delivering solid growth in fundamentals like sales, cash flow, and dividends.
When it comes to the quality of the business, and its management, Microsoft under Nadella is unquestionably far superior to IBM under Rometty.
Ultimately I'm not just interested in dividend stocks for the income, but because they are a proven source of great total returns over time. Total returns are a function of three things: yield + long-term earnings/cash flow growth (which dividends track) + valuation change.
|Company||Yield||5 Year Expected Earnings Growth (Analyst Consensus)||Total Return Expected|
Valuation-Adjusted Total Return Potential
|S&P 500||1.9%||6.4%||8.3%||3% to 8.2%|
IBM certainly offers the superior yield, nearly triple that of Microsoft. And despite overpaying for Redhat and blowing up its balance sheet, the dividend is still relatively safe. However, while Microsoft's current yield may be paltry, it's expected to grow earnings and cash flow nearly six times as fast as Big Blue. Morningstar actually expects 15% EPS growth from MSFT compared to 6.1% from IBM and they are usually conservative in their growth assumptions.
While all long-term growth forecasts must be taken with a grain of salt (educated guesstimates) in this case Microsoft's strong execution on cloud makes me think that 12% to 15% long-term earnings growth is a reasonable expectation. In contrast even that 2.3% consensus on IBM might be hard to achieve given the company's ongoing struggles with its legacy hardware businesses and slowing SI sales growth.
That's not to say that I consider IBM a "sell" necessarily. After all, that attractive dividend should allow IBM to deliver close to the market's forward total returns in the coming years, as long as management can deliver on those VERY conservative growth estimates.
But compared to Microsoft's return potential, which is about three times that of the market and about double that of IBM, the better long-term investment from a total return perspective is obvious.
All companies face risks to their growth plans, and IBM and Microsoft are no different. The biggest risks investors need to be aware of is the cutthroat and fast pace of change in an industry that is at the heart of disrupting so many sectors of the global economy.
Cloud is an enormous, fast growing and high margin industry with tech giants like Amazon, Alphabet, and Alibaba investing billions each year to improve their offerings and trying to steal market share. And there are dozens of smaller players, who are trying to out-innovate and or compete on price, which potentially could disrupt Microsoft's dominant industry position.
Now it's true that network effects are strong in cloud, which is why the industry's top names (other than IBM) have been steadily gaining market share. However, rising margins in cloud are largely due to enormous economies of scale and not rising prices. For example, Amazon has cut its AWS prices 67 times over the past 12 years (yet AWS margins keep rising).
Microsoft's strong R&D efforts might be able to keep margins rising for several more years but eventually, they will likely peak and slow earnings and cash flow growth from the cloud (at least from margin expansion).
Still, that's far superior to IBM's position which is weak and getting weaker, as seen by its declining margins in all segments, including SI and cloud.
The other big risk to consider is that in order to compete with several giant and well-funded rivals Microsoft is going to occasionally make big acquisitions, as seen under Nadella with LinkedIn and Github.
While LinkedIn appears to have been a success, it's still too early to say whether $7.5 billion for Gitbub will prove a wise move. The strategic rationale for that deal is very ephemeral, while IBM's buying Redhat is much easier to understand (if not likely to actually restore it to strong growth).
This is why it's important for investors in tech dividend stocks to watch ROIC trends over time to make sure that management is allocating capital wisely, and not merely empire building.
Finally, we can't forget that high R&D spending is the lifeblood of tech (you can't grow your way to great success only on acquisitions). Microsoft's rapidly rising R&D budget and cloud-based capex have thus far paid off, but with complex and large corporations, there is no certainty that such investments will always come out profitably.
This is why FCF/share is another critical quality metric to watch over time. While tech companies can be applauded for pouring billions into expanding their businesses, ultimately FCF/share is what funds dividends and if that doesn't grow over the long-term then I can't recommend even a fast growing and industry-leading company.
But again, these risks are shared by all dividend-paying cloud companies, and at the end of the day, Microsoft is far better positioned to navigate these fast-changing waters than floundering and soon to be hyper-leveraged IBM.
A big reason so many income investors like IBM is due to its low valuation, which isn't surprising given how poorly shares have done over the past year (or five). And with Microsoft having crushed the market over the past 12 months many understandably consider MSFT richly priced.
|Company||Forward PE||5 Year Average PE||Growth Rate Baked In|
Expected Growth Rate
|Average Tech Company||17.6||NA||5.4%||NA|
From a forward PE perspective that makes sense given that Microsoft is trading at a premium to both its historical forward PE and that of most tech companies. IBM is trading at a slight discount to its historical forward PE which bakes in even slower growth than analysts expect. But note that Microsoft's PE isn't actually that high for a company that's expected to grow at low to mid-double-digits.
And when I look at both companies via my favorite valuation tool for income stocks, dividend yield theory, then IBM too seems like the obvious valuation winner.
DYT is what asset manager/newsletter publisher Investment Quality Trends has been exclusively using since 1966 to deliver decades of market-beating returns from blue-chip income stocks. This valuation method compares a company's yield to its historical yield because, assuming fundamental conditions (like growth rates) are similar, yields are mean reverting over time and historical yields approximate fair value.
|Company||Yield||5 Year Average Yield|
Potential Discount To Fair Value
DYT (which is what I officially use to buy companies for my portfolios) says Microsoft is about 27% overvalued while IBM is 19% undervalued. However, I don't actually consider Big Blue's margin of safety that high because its poor quality management team continues to underdeliver on ever weakening growth guidance.
In other words, if IBM can't return to consistent earnings and cash flow growth then I don't expect its yield to actually return to that 3.6% average yield, but rather the average yield to rise over time to match the current yield (IBM could be a value trap).
But how can I claim that MSFT is tied with IBM in terms of valuation when two popular valuation methods show IBM as the apparent winner? That would be using the final valuation approach I consider, Morningstar's three-stage discounted cash flow model.
|Company||Morningstar Fair Value Estimate||Discount To Fair Value||Upside To Fair Value||Long-Term Valuation Boost|
Valuation-Adjusted Total Return Potential
While no DCF model can be taken as gospel (all include numerous growth assumptions and discount rates that are actually different for all investors) I consider Morningstar's fair value estimates to be the gold standard as far as Wall Street analysts go.
Morningstar is slightly more bullish on both companies compared to the analyst consensus but considers both cloud companies to be roughly equally undervalued. While I'm not necessarily as bullish on IBM as Morningstar is, in this case, I'm willing to give IBM the benefit of the doubt despite its long-term growth prospects being far less certain than Microsoft's.
But the point is that given Microsoft's vast superiority in all other important categories, I consider it a decent buy at today's prices for most income investors. Personally, I consider IBM a "hold" until I see them actually post steady bottom line growth and prove that Redhat isn't a costly mistake.
If you have more confidence in Rometty than I do, then IBM is a decent buy BUT just make sure to size your position appropriately in case management continues its well-established track record of overpromising and under delivering.
Don't get me wrong, I understand why high-yield income investors might choose IBM over Microsoft. After all, the relatively safe 4.5% yield is triple what Microsoft offers, and if you're retired and need dividend to pay the bills, stronger long-term growth is less of a concern.
But from a fundamental and valuation perspective, I have to still recommend Microsoft over IBM for most long-term investors. That's because on every important metric that matters, including management quality, profitability, growth outlook, and even valuation, Microsoft matches or beats IBM by a wide margin.
IBM's bullish thesis is entirely based on a low valuation and long-promised turnaround that management keeps failing to deliver, and that analysts (and I) have basically lost confidence in. On the other hand, Microsoft's vast cloud empire continues to grow like a weed under the expert guidance of Satya Nadella.
When it comes to choosing lower quality deep value over high-quality growth, I'm with Buffett on this one "it's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."
Well, today I've shown that Microsoft is not just a wonderful company, but arguably somewhat undervalued. Meanwhile, IBM, a fair company at best, may not be as undervalued as the PE ratio and high-yield might initially indicate.
The bottom line is that when it comes to cloud computing dividend growth stocks, Microsoft is a far better buy than IBM.
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