Cash-Rich Tech Outfits Should Consider Dividends
By Nicole Ridgway
June 26, 2007

TECH STOCKS AND dividends haven't always gone hand in hand. After all, investors once believed that tech outfits should be spending their cash on acquisition sprees and R&D — not paying dividends.

In recent years that conventional wisdom has been thrown out window. A 2003 change in tax law, which cut taxes on dividends by more than half for investors, helped spark a renaissance in the dishing out of dividends. But there's also another interesting catalyst for dividends in the tech sector: cash — and lots of it.

"Right now, one-third of the assets of technology companies are in cash," says Jason Trennert, managing partner and chief investment strategist at Strategas Research Partners. "Ten years ago it was half that."

And while some companies would be better off spending their cash on buying a close rival or expanding their operations organically, there are some dividend-paying tech stocks that offer the best of both worlds. Indeed, investors who do their homework may find an investment that not only guarantees a nice little payout every year, but also the steady growth rates that tech stocks have long promised. To some, it's the perfect tonic in this post-tech-bubble world.

"Right now, folks are really interested in additional value," says Scott Kessler, head of technology-sector equity research at Standard & Poor's. "I think shareholders are growing increasingly impatient with assets that wallow on company balance sheets."

Microsoft's (MSFT) decision to submit to its own shareholders' demands in 2003 is a prime example. That's when the company, which had vats of cash, decided to start paying its first annual dividend of eight cents per share. By the summer of 2004, the software giant still had a staggering $56 billion in cash on its books. Understandably, shareholders wanted a much bigger piece of that stash.

In what might have seemed like an over-the-top response, Microsoft upped its regular dividend to 32 cents a year, tacked on a special one-time dividend of $3 a share and initiated a stock buyback of up to $30 billion. In total, the plan entailed that Microsoft fork over up to $75 billion over the next four years.

Microsoft was a prime candidate for dividend payouts. The company generates so much extra cash that it can afford to return some of it to investors while continuing to invest in growth. Offering dividends hasn't done much to ignite Microsoft's shares, however. Since July 2004, the stock has climbed only 7%. Nevertheless, investors now earn 40 cents a share per year in dividends, a current yield of 1.3%. (Yield is the annual dividend payout divided by the stock price.)

While Microsoft's stock may have been stuck in the mud, Wall Street is betting that it won't be forever. According to Thomson First Call, analysts have a median price target of $35 on the shares, implying an almost 17% upside for the stock. The catalysts for Microsoft's anticipated earnings growth are large: Not only did Microsoft just release Vista, its first new operating system in five years, but it's also taking advantage of the online ad boom, spending $6 billion to buy online ad network aQuantive (AQNT) — the biggest acquisition in its history.

Not every big tech bellwether has followed Microsoft's suit, namely cash-rich holdouts in the sector like bellwethers Cisco Systems (CSCO) and Oracle (ORCL). Given the cash that both of these companies have on their books — more than $5 billion apiece — there's plenty of money to fuel new growth initiatives and pay dividends. Yet shareholders — who still might consider the payment of dividends as a sign of slow growth and aging — may not see it that way. "The thinking is that if Oracle or Cisco came out and started paying a dividend that it would negatively affect the stock," says S&P's Kessler. "I don't think that would be the case. They could be paying a dividend and growing their business."

Of course, not every tech company has as much in its piggybank as the tech giants. And those that do offer dividends tend to offer pretty small ones. According to data from Reuters, the average yield in the tech sector is 1.28%. That's a far cry from the average yield of S&P 500 index stocks, which comes in at 2.12%.

True seekers of dividend payouts may find some slim pickings in the tech sector, but not all hope is lost. For example, low-cost Internet service provider United Online (UNTD) serves up a healthy annual dividend of 80 cents a share, offering an impressive 4.82% yield. On top of that, the company's growth prospects are pretty impressive.

United Online made some smart acquisitions to fuel growth and offset losses in its ISP business. In 2004, it tapped into the hot social-networking trend by buying Classmates.com. Then, last year, it bought MyPoints.com, which offers customers advertising-based reward points. The two businesses, which are part of the company's Content and Media group, saw a 64% jump in year-over-year revenue during the company's latest first quarter. Year-to-date, United Online's stock is up nearly 20%.

While United Online is one tech company that has made good use of its cash for investors, there are plenty of others that have not. Investors should keep a close eye on the way a company uses its cash. How much of it goes back into R&D, for example? And are there signs that the company is engaging in empire-building — or buying one company after another just to increase its power? "The things that destroy value are bad acquisitions or bad capex [capital expenditure] plans," says Strategas's Trennert. "Not dividends."

As David Hilal, the senior managing director of equity research at Friedman Billings Ramsey explains, whether or not a tech company should be paying a dividend should be determined on a case-by-case basis. A small-cap company that decides to pay a dividend could very well have run out of growth opportunities. He also suggests that potential investors look at the company's market opportunity and whether or not there are new, complementary markets that the company can enter into either through an acquisition or organically. "If [so], it's probably a better use of that cash to pursue those opportunities than to pay a dividend," he says.

(For other tech outfits that have plenty of cash on their balance sheets, a fairly solid return on equity and healthy expected earnings growth that we think should consider paying a dividend, please see the table above).