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Microsoft’s new buyback and larger dividend sweeten the deal

Software giant Microsoft  (NASDAQ: MSFT )  has been drawing a lot of attention to itself over the last few months. First, we get the bombshell that CEO Steve Ballmer would be retiring within a year, and as though that weren’t enough, the company then drops a cool US$7.2 billion on Nokia‘s handset division. While it’s arguable as to whether those two developments are positives or negatives, the company recently announced an unequivocal win for shareholders: a dividend increase and a gigantic US$40 billion share buyback.

That sweet yield

Dividend-growth investing is one of the safest, and most lucrative in the long haul, methods of investing. This is why investors who tend to enjoy more conservative, income-oriented investments tend to look at both the current yield as well as the company’s track record for increasing that dividend at a consistent rate. Microsoft, in true dividend-growth fashion, just announced a whopping 22% increase in its dividend–US$0.28 per share quarterly, US$1.12 per share on an annual basis. That’s nearly a 3.5% yield at current levels, better than the 10-year Treasury that yields around 2.8% with absolutely no room for capital gains.

What a buyback!

Great yield and cheap valuation ahead of what could be a new dawn for the company are enough to pique one’s interest, but what’s really compelling is the company just announced an eye-popping US$40 billion buyback, good for roughly 14% of the shares outstanding. Not only does this boost earnings per share, but a buyback of this magnitude can introduce some serious buying pressure on the stock, which can further ignite long-term share price appreciation.

Speaking of capital gains, Microsoft is poised for plenty

While I’m a big fan of the dividend, I really view it as being paid to wait for the capital gains to come in. Look, while much has been said about how Microsoft is “missing the boat” in mobile, or how Windows 8 is a flop, the bottom line is that only 25% of the company’s business is tied to Windows at all! The remaining portions – business, server & tools, online services, entertainment & devices – comprise the remaining 75% of the company’s revenue base.

With the current CEO on his way out over the next year (which means room for fresh new leadership and vision), coupled with a well-diversified (and mostly growing) business, and dirt cheap 7.15x EV/EBITDA valuation, it seems that the risk really is to the upside on the shares at current levels.

Windows 8.1 and the end of Windows XP support could make for a great 2014

While Windows 8 uptake isn’t great, particularly as the vast majority of PCs haven’t yet moved to touch, there is room for cautious optimism with respect to Windows 8.1. It adds back a lot of the features and functionality that many, particularly non-touch users on PCs, were missing, and at the same time makes the touch experience better.

Add to a better OS a wider and deeper lineup of devices ranging from quality 8″ tablets powered by Intel’s upcoming “Bay Trail” to a sea of “Haswell” based thin and light notebooks with excellent battery life, and Microsoft really seems poised for share gains across the entire spectrum of computing.

Furthermore, Windows XP is set to go “end of life,” which means that it will no longer be supported by Microsoft via updates. This could drive refresh in the corporate space, which has been softer than usual over the last year or so.

The Nokia purchase could do wonders

In addition to shoring up its core Windows business, I remain optimistic that Microsoft’s purchase of Nokia’s device business could eventually pay off big in the future. While it’s not reasonable to expect that Microsoft will become the “next Apple,” Microsoft can leverage its brand and the talent and IP from Nokia to sell a line of smartphones profitably. It’s not clear how much upside this will drive for the company, but the potential seems there.

The Foolish bottom line

Microsoft sports a great yield, generates plenty of cash, and is now unleashing a gigantic buyback program. All of this comes just ahead of what could be a dramatic turn in sentiment for the software giant thanks to the upcoming Windows 8.1 launch and the imminent installation of new leadership. I like Microsoft here and think there’s plenty of potential for both dividend growth as well as capital appreciation.

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More reading

A version of this article, written by Ashraf Eassa, originally appeared on fool.com.

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