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Forget IBM. Microsoft Is a Better Dividend Growth Stock

John Ballard, The Motley Fool

For more than a century, IBM (NYSE: IBM) has been a great dividend stock for investors. The company has paid a dividend every year since 1916 and has increased the dividend for a current streak of 18 years in a row. Its 4.7% current dividend yield is tempting in a low-interest rate environment, especially compared to the lower S&P 500 yield of 2.1%. 

However, IBM faces several challenges that have made it difficult for the company to grow in recent years. This could put pressure on the company's ability to increase the dividend going forward. Although Microsoft's (NASDAQ: MSFT) yield is lower, the company is growing and has plenty of cash resources to keep increasing its dividend over time.

A plant growing out of a pile of coins with a city skyline in the background.

IMAGE SOURCE: GETTY IMAGES.

IBM is getting left behind

For several years, IBM has been gradually shifting its revenue from legacy hardware and services to faster-growing areas, such as blockchain, cloud, mobile solutions, and data analytics to position itself for long-term growth. However, as it does so, Big Blue is entering areas where more nimble competitors have already beaten it to the punch and are well entrenched.

This is most notable in IBM's cloud business (about 24% of total revenue), where the company is way behind Amazon.com and Microsoft -- the top two market-share leaders. More and more corporations are moving their entire data systems over to the cloud. Amazon has garnered the top spot in the cloud market with 52% market share, according to research firm Gartner. Microsoft was late to the cloud market but caught up quickly, earning the second spot behind Amazon with 13% market share. Meanwhile, IBM has only managed to capture 2% of the market.

Microsoft's Azure cloud business grew revenue 76% year over year in the third quarter, faster than Amazon Web Services. With every corporate customer Microsoft picks up, that's one less customer for IBM.

IBM is not showing any sign of catching up to its rivals. Amazon and Microsoft are the hares in this race, while IBM is the slow-moving tortoise. That's why IBM went out and spent $34 billion recently to buy Red Hat, to essentially buy its way to the top of the cloud, but some analysts remain skeptical about IBM's strategy. 

If IBM doesn't grow, dividend increases will get difficult

Big Blue has been trying to improve its growth for many years and hasn't managed to get the needle moving. Over the last 10 years, IBM's revenue and free cash flow -- out of which dividends are paid -- hasn't grown, as you can see in this chart. Also, note how IBM's operating performance is a mirror image of Microsoft's steady growth.

IBM Revenue (TTM) Chart

IBM Revenue (TTM) data by YCharts.

The challenges IBM faces are so severe that one analyst boldly stated that Big Blue's earnings are in an "irreversible structural decline." Many other investors seem to have the same opinion, which is why IBM stock trades at such a low price-to-earnings ratio and offers such a high dividend yield. Analysts expect the company to grow earnings just 0.96% over the next five years. 

IBM has managed to grow its dividend payout per share 207% over the last decade, but that's due to an increase in the payout ratio from less than 20% of free cash flow to 44% over the last year. Also, the company artificially boosted its dividend per share by repurchasing shares. 

Additionally, IBM has $21.5 billion of net debt on the balance sheet with another $15.8 billion in retirement-related obligations, which could make it difficult for the company to increase the dividend going forward. That level of debt doesn't include the financing required for the $34 billion Red Hat acquisition, which will be financed by a mix of cash and debt. 

A better dividend stock for the long haul

In stark contrast, Microsoft is soaking in cash, and operating performance has been stellar. At the end of the third quarter, the software giant had $59.7 billion of net cash and generated $32 billion of free cash flow over the last year. Microsoft pays out 40% of free cash flow in dividends. 

Metric IBM Microsoft
Cash $14.5 billion $136 billion
Debt $47 billion $76 billion
Revenue (TTM) $80 billion $115 billion
Net income (TTM) $5.7 billion $19 billion
Free cash flow (TTM) $12.7 billion $32 billion
Dividend yield 4.7% 1.7%
Dividend payout as a percentage of free cash flow 44.2% 40.4%
Forward price-to-earnings ratio 8.75 20.93

Data source: The companies, Y-Charts, and Yahoo! Finance. TTM = trailing 12 month.

While IBM's moat appears to be steadily shrinking, Microsoft enjoys a wide moat based on its dominance with its Windows operating system, and the familiarity users have with its Office software. More of Microsoft's revenue is coming from recurring subscription fees, such as Office 365. The software giant has seen steady growth in its flagship Windows and Office products lately. 

Analysts expect Microsoft to grow earnings 14% per year over the next five years, which is consistent with the company's recent performance. At that rate of growth, profits and free cash flow would nearly quadruple over the next decade. Microsoft could increase its dividend payout by a proportionate amount.

Take a look at the chart below. Over the last 10 years, Microsoft has increased its dividend at a slightly faster pace than IBM even though Microsoft pays out slightly less of its free cash flow as dividends.

IBM Dividends Paid (TTM) Chart

IBM Dividends Paid (TTM) data by YCharts.

IBM's dividend increases were made by increasing the payout as a percentage of free cash flow, while Microsoft increased its dividend partly through growth in free cash flow, which is ideally what dividend investors want to look for.

Successful dividend growth investing can be very rewarding down the road, as those dividend payments get larger and larger, and it's not difficult to achieve. You stack the odds enormously in your favor by investing in a company that has demonstrated growth in free cash flow and avoid companies that haven't.

Over the long term, investors are better off investing in wide-moat Microsoft, which can consistently grow its revenue and profits to finance higher dividend payments over time. Microsoft offers investors both potential capital appreciation and rising income over time; those are two things that IBM may not be able to generate for shareholders.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool's board of directors. John Ballard owns shares of Amazon. The Motley Fool owns shares of and recommends Amazon. The Motley Fool owns shares of Microsoft. The Motley Fool recommends Gartner. The Motley Fool has a disclosure policy.