International Business Machines (IBM) is a technology company that provides software and hardware services and products, including cloud and artificial intelligence. We are neutral on IBM stock.
Years of Underperformance
IBM stock has underperformed for many years. When taking a look under the hood, it’s easy to see why. Although the dividend has been increasing, revenues and earnings have steadily been decreasing for a decade. Free cash flow was also in decline for most of the past decade but has seen a substantial uptick in 2020 and the last 12 months.
It’s important to keep in mind that IBM spent over $30 billion to acquire Red Hat in 2019. Thus, it has taken three years to generate enough free cash flow to recoup the money spent. However, that’s for all operating segments; the acquisition itself is probably generating between $1 billion to $2 billion in free cash flow (FCF for Red Hat was around $1 billion in 2019).
In addition, of the company’s 12 operating categories, only four of them actually grew. This demonstrates that there is a lot of dead weight on its books.
Potential Growth Catalysts
IBM is attempting to offload lagging business units, having recently spun off Kyndryl (KD). The idea is that by focusing on its core segments, it will return to growth. By freeing up resources, it will be able to provide better services.
The company is now exploring the sale of its money-losing Watson Health artificial intelligence business. After spending approximately $4 billion to create the unit, IBM is looking to offload it for around $1 billion. Although the impact will be minimal (the unit generates $1 billion in revenue), it shows its commitment to the strategy.
Therefore, investors should expect to continue seeing declining revenues until IBM is done cleaning up its operations. Ideally, this should help improve margins and free cash flow going forward.
Dividend
Investors of IBM stock are generally mostly interested in the dividend. Currently, it has a 4.81% dividend yield which is significantly above the sector average of 0.69%. When taking a look at its LTM free cash flow figure of $13.8 billion, its $5.8 billion dividend payment looks safe.
Taking a look at its dividend yield trend, we can see that IBM’s dividend yield has remained relatively flat over the past several years. At 4.81%, the company’s dividend is near the lower end of its range, implying that it is on the higher end of its valuation range.
However, IBM needs to be responsible with its acquisitions going forward if it wants to sustain its dividend growth. It currently has almost $53.2 billion in debt, with a big chunk of that being attributed to the Red Hat acquisition in 2019.
With interest rates expected to rise, it would be unwise to take on more debt to complete another massive acquisition. Such a move would undoubtedly strain its cash flow and put dividend growth at risk.
Wall Street’s Take
Turning to Wall Street, IBM has a Moderate Buy consensus rating, based on five Buys and three Holds assigned in the past three months. The average IBM price target of $155.90 implies 15.6% upside potential.
Conclusion
IBM has been underperforming for years. Management is aware of this and is trying to return the company back to growth. That said, we would rather wait to see if its right-sizing strategy will actually work to return the company to growth and keep the dividend safe. As a result, we remain neutral on IBM.
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Disclosure: At the time of publication, StockBros Research did not have a position in any of the securities mentioned in this article.
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