Published on July 9th, 2019 by Eli Inkrot
International Business Machines (IBM) is a global company focusing on supplying technology and business services, software and systems hardware throughout the world.
“Big blue” was once thought to be the ultimate blue-chip stock, but has run into problems sustaining growth in the last decade. Today, this Dow Jones Industrial Average member offers a different type of value proposition.
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IBM’s current dividend yield now sits at 4.6% – a mark that would have been inconceivable to investors just a short while ago. Moreover, IBM has increased its dividend for 24 consecutive years. An increase next year will make IBM eligible to become a member of the Dividend Aristocrats, a group of 57 stocks in the S&P 500 Index with at least 25 years of annual dividend increases.
We rate IBM as a buy for income and value investors.
IBM focuses on large, multi-national customers and running mission critical systems, often providing end-to-end solutions. The company offers IT solutions, middleware software (connecting applications and devices), mainframes and servers.
IBM breaks its business down into five segments:
- Cognitive Solutions
- Global Business Services
- Technology Services & Cloud Platforms
- Global Financing.
Here is how each of those segments contributed to IBM’s top line in 2018:
Source: IBM 4Q18 Press Release
Cognitive Solutions made up 23.2% of the total, Global Business Services 21.1%, Technology Services & Cloud Platforms 43.3%, Systems 10.1% and Global Financing 2.0%.
Looking at the total revenue figure, $79.6 billion, is helpful in understanding the business in a couple of ways. For starters, it gives you an idea of the company’s composition. More importantly, you can also review IBM’s history over the longer-term to get a better feel for how the company has been progressing (or not progressing) in the last decade.
In 2009 IBM generated $95.6 billion in revenue. This number grew nicely from 2009 through 2011, reaching $106.9 billion. This turned out to be the peak. Since that time IBM recorded revenue of $104.5, $99.8, $92.8, $81.7, $79.9 and $79.1 billion in revenue (respectively) from 2012 through 2017. That represented six consecutive years of declining revenue for IBM.
There are three important offsetting factors to the “doom and gloom” characterization of IBM’s revenue. First, while revenue has steadily declined, IBM’s net profits have actually held up reasonably well – coming in around $12 billion in 2008 and above $12 billion in 2017 – as the company shifted to higher-margin businesses.
Second, IBM repurchased a large number of shares in the last decade, meaning that earnings-per-share still increased during this time. And third, while analyzing past results is helpful, it does not necessarily indicate that the future will follow the same pattern.
To this last point, revenue actually increased 0.6% from 2017 to 2018. This has been years in the making. While total revenue at IBM has been shrinking in the last decade, the responsible party has been the company’s legacy businesses.
IBM’s growth businesses are known as “strategic imperatives” which include things like cloud, analytics, mobile and security. These aspects are intermingled in the above business segments, but represent a different growth profile compared to IBM’s historically important businesses.
Here’s a look at how “strategic imperative” revenue has been growing over time:
- 2014: $25.0 billion, up 16%
- 2015: $28.9 billion, up 16%
- 2016: $32.8 billion, up 13%
- 2017: $36.5 billion, up 11%
- 2018: $39.8 billion, up 9%
And this is how the various strategic imperative components looked to end 2018:
Source: IBM 4Q 2018 Earnings
This portion of the business, which continues to grow at a nice clip, now makes up half of IBM’s business.
Granted the pace of growth will slow as time moves on, but it is an important (and positive) consideration nonetheless. IBM’s strategic imperatives should continue to fuel the company’s future growth.
As illustrated above, the tide has finally begun to shift in IBM’s growth profile. If the company failed to adapt, both IBM’s legacy businesses and its overall business would continue to decline, as was evident in the last decade.
However, that is not the situation that the company finds itself in today, as the investment in the strategic imperative portion of the business has buoyed its revenue.
IBM’s legacy businesses will continue to decline. This is not ideal, but it does allow for two things. First, these segments continue to generate a solid amount of cash that can be reinvested elsewhere. Second, as the decline continues, the legacy businesses become less and less important to IBM overall.
Meanwhile, as the strategic imperative businesses continue to grow, they become a larger and more important part of IBM. As a result, IBM has finally reached the inflection point where the overall top-line is starting to grow.
A second consideration is IBM’s recent $34 billion acquisition of Red Hat to become the world’s #1 Hybrid Cloud provider. Red Hat will operate as a distinct unit within IBM’s Hybrid Cloud team and the transaction is expected to close in the latter half of 2019. While some have suggested that IBM paid too much, the growth narrative is undeniable.
Red Hat grew earnings-per-share by nearly 20% per annum during the last decade. Meanwhile, IBM was only growing earnings-per-share by 4.5% during the same timeframe. Moreover, this accentuates IBM’s push into strategic imperative business.
Source: IBM Presentation
For the first time in a long time, IBM has a growth runway in its sights. In the meantime, the stock has an attractive valuation and dividend yield, leading to a strong overall expected return profile.
Valuation & Expected Return
Shares of IBM currently trade hands around $141. Management has indicated that it expects to generate operating earnings-per-share of at least $13.90 this year, which we will use as our beginning baseline.
That works out to a starting P/E ratio of ~10.1 compared to a historical multiple near 12 during the last decade. And remember, IBM did not exactly post a terrific growth record during this time.
As mentioned above, IBM now has growth levers available. The strategic imperative segments were already starting to pull the company toward growth and the Red Hat acquisition could take that to the next level. Moreover, IBM generally keeps a conservative balance sheet, allowing for additional bolt-on acquisitions down the line.
Collectively, it’s not unimaginable that IBM could grow its bottom line at 3% per year over the next half decade. If this were to come to fruition IBM would be earning $16.00 or so per share (using round numbers) in five years. Using an average historical valuation of 12 times earnings, this could equate to the potential for a $192 share price.
IBM’s dividend presently sits at $1.62 per quarter or $6.48 on an annual basis (taking up ~47% of expected profits and working out to a 4.6% dividend yield).
We believe IBM’s dividend is secure, which we further illustrate in the following video:
In all likelihood IBM’s dividend will increase over time, just as it has done for more than two decades now. If this payout were to also increase by 3% annually, you might expect to collect ~$34 in cash dividends per share during the next five years.
Combined, that works out to a nominal value of ~$226 after half a decade, keeping this in mind as a starting place and certainly not an absolute. Now whether or not this appears interesting depends on IBM’s current share price.
If shares were trading at $226, naturally a 0% expected return for the next five years would not be interesting. On the other hand, against today’s $141 share price, this implies the potential for an annualized return of about 10% per annum.
Furthermore, should growth come in at a higher rate or the valuation expand to a greater degree, future returns could be even more impressive.
IBM has been a storied company in an industry that demands adaptation. In the last decade the company’s growth has been severely called into question, and with good reason as revenues steadily declined by more than 25% in the 2011 through 2017 period.
However, it seems that the “doom and gloom” outlook may not last forever. In the background of IBM’s declining legacy business, the strategic imperative segments have meaningfully contributed. Back in 2014 strategic imperatives made up 27% of IBM’s business.
Now, less than five years later, these future technologies are half of IBM’s business and still growing at a solid clip. Furthermore, IBM’s acquisition of Red Hat could further shift the dynamics of the company’s growth profile.
Despite the lackluster results in the last decade, IBM is proving that it is capable of adapting, just as it has done for over a century now. Growth is finally on the horizon once again.
At the same time, IBM’s valuation is looking more compelling. Shares now trade at 10.1 times expected earnings with a 4.6% dividend yield. IBM is an undervalued dividend stock.