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International Business Machines (IBM) Dividend Stock Analysis

Summary

International Business Machines is a large provider of IT systems, software, and hardware.

-Five-year Revenue Growth: 3%
-Five-year EPS Growth: 15%
-Dividend Yield: 1.58%
-Five-year Dividend Growth: 21%
-Balance Sheet Strength: Moderately Strong

I consider IBM to be a reasonable buy at current prices of under $190, but rather than being a “dividend stock“, it’s better described as a large cap company that happens to pay a small dividend. If I were interested in buying the stock, I’d wait for dips.

Overview

IBM is a 100-year-old technology company, focusing on providing business technology. As of 2010, 44% of income comes from software, 39% comes from services, 9% comes from financing, and 8% comes from hardware.

Revenue, Earnings, Cash Flow, and Metrics

IBM has experienced reasonable growth for a large company.

Revenue Growth

Year Revenue
TTM $106.4 billion
2010 $99.9 billion
2009 $95.8 billion
2008 $103.6 billion
2007 $98.8 billion
2006 $91.4 billion

Revenue growth has averaged about 3% per year over this period.

Earnings Growth

Year EPS
TTM $12.87
2010 $11.69
2009 $10.12
2008 $9.07
2007 $7.32
2006 $6.20

EPS has grown by over 15% per year, on average, over this period. This is a substantial figure for a large-cap company.

Operating Cash Flow Growth

Year Cash Flow
TTM $19.5 billion
2010 $19.5 billion
2009 $20.7 billion
2008 $18.8 billion
2007 $16.1 billion
2006 $15.0 billion

Cash flow has grown by over 5% per year over this period, on average. The company regularly converts around 75% of operating cash flows to free cash flows.

Metrics

Price to Earnings: 15
Price to Book: 10
Price to CF: 11.5
Price to FCF: 15
Return on Equity: 70%

Dividends

IBM has begun a solid string of dividend increases, but the yield remains well below what dividend investors normally look for. The dividend yield is currently 1.58%. IBM has raised its dividend for 16 consecutive years.

Dividend Growth

Year Dividend
2011 $2.90
2010 $2.50
2009 $2.15
2008 $1.90
2007 $1.50
2006 $1.10

Over these last five years, IBM has grown its dividend by over 21% per year, on average. The most recent quarterly growth was from $0.65 to $0.75, which represents growth of nearly 15% for the year.

The dividend payout ratio is under 25%. This results in a safe dividend, but a low yield. Since dividend growth outpaces EPS growth, the dividend payout ratio is increasing, which I think is a good thing for a large, shareholder-friendly company to do. If this continues, IBM should eventually grow a respectable dividend yield like some other large cap tech companies have, but will have a rather low yield for quite some time.

Share Repurchases

IBM maintains a fairly low payout ratio, and puts a considerable amount of cash flow towards buying back their own shares. This has several outcomes:
1) It divides dividend payments and net income over a smaller and smaller pool of shares, therefore accelerating EPS and dividend growth.
2) Increasing EPS should result in increasing stock price unless the valuation decreases.
3) It is good for management pay packages (targets, options, etc)
4) It results in a lower dividend yield than many other large cap companies.
5) It saves some tax for investors that invest in accounts that are not tax-sheltered, but gives investors significantly less freedom to choose what to do with the money that gets sent their way each year.

Overall, I feel that IBM does dividend repurchases better than most companies, since they do them year after year and decrease the number of shares significantly over time, but I would very much prefer a 3% dividend yield or more in exchange for less capital put towards share repurchases.

Balance Sheet

IBM has moderately high balance sheet strength. It’s a bit weak in the sense that the total debt/equity ratio is 1.25, and goodwill on the balance sheet slightly exceeds total shareholder equity. This debt makes the return on equity rather high. Part of this somewhat unattractive debt/equity balance has to do with the fact that IBM’s products are basically information. The company produces a lot of software and services, and the hardware that they produce carries good margins due to being complex computing mainframes and such. All of this is to say that IBM doesn’t need much in the way of assets to operate (compared to its total company size, that is), and so debt skews the metrics a bit more than it would for a company that relies on more assets. This is evidenced by the extremely strong interest coverage ratio of 50; bond holders and credit raters view the balance sheet risk as low.

Investment Thesis

IBM has appealing and precise long-term goals. A number of years ago, IBM had the target of $10-$11 in EPS for 2010, and they surpassed that goal through the worst global recession in recent history. The company over the last several years has turned more towards software and services and away from hardware, while holding onto the hardware businesses in which they dominate the market (like mainframes).

Transforming the Business
Over the last decade, IBM transformed itself. Commodity businesses of PCs and hard drives were sold off, and the company made 116 acquisitions, of which a large portion were in the area of software and services. The company received nearly 6000 patents in 2010, of which significantly more than half were software or services related. Today, as a percentage of total IBM income, IBM’s hardware segment generates only a third of the income that it did in 2000 (8% of the total compared to 24% of the total).

IBM has a strong presence in the areas of business. It has its mainframe business for high-end computing, along with servers, operating systems, middleware, IT infrastructure management, and application software and analytics. A lot of this is based on platforms; things you design other applications around that therefore carve long-term niches for themselves (since companies that engineer software for a particular system don’t find it cost-effective to completely overhaul their product or system too often). IBM therefore generates a lot of recurring cash flows. Global volumes of data are now up to inconceivable levels, and large companies like IBM provide billion-dollar solutions to organize it into useful forms. The company markets itself as an integrated provider, meaning that if an enterprise has IT needs, IBM can provide most of them.

2015 Road Map
In 2010, IBM released its 2015 road map, which sets the 2015 EPS target at a minimum of $20. The TTM EPS is about $12.69, so over the next four years, EPS growth would need to be 12% per year on average to reach this target.

There are more specific predictions and explained paths that lead to that number. IBM wants the percentage of its business coming from high-growth countries to be 30% by 2015, up from 21% in 2010 and 11% in 2000. The company expects to continue share repurchases and dividends into 2015, with a summation of $50 billion in share repurchases and $20 billion in dividends for the time period between 2010 and 2015, which comes from the $100 billion in free cash flow they expect to have generated. (Share repurchases were a large component of the 2010 target, and will be a large component of the 2015 target). Another $20 billion is expected to be spent on acquisitions over this period. Revenue from the “cloud” in 2015 is expected to be $7 billion. Revenue from analytics in 2015 is expected to be $16 billion (and global data volume is predicted to multiply in volume by 29 between 2010 and 2020). Revenue from their “Smarter Planet” area is expected to be $10 billion by 2015. Overall, half of earnings are expected to come from software in 2015, with the other half coming from the combination of services, hardware, and financing.

An annual 12% increase in EPS, combined with a 1.5% dividend yield, results in 13.5% annual returns through 2015, assuming the valuation remains constant. This would be superior to historical broad-market returns. Total returns could be increased or decreased if the earnings multiple of the stock in 2015 is higher or lower than the reasonable current earnings multiple of 15. IBM could exceed their targets again, and the valuation could be higher, but I’d propose making more conservative estimates of a lower valuation and a slight miss in EPS targets.

Risks

As a large technology company, IBM faces many risks. Computing has evolved from isolated networks to the world wide web, and is now shifting towards mobile computing, server-based computing (cloud), and using increasingly small and powerful processors to make everything we interact with intelligent; appliances, infrastructure, etc. IBM needs continually update its software offerings and services to be relevant, or continue to use its huge source of capital to make appropriately-valued strategic acquisitions of competitors. Potential slowdowns in high-growth countries, enormous European debt issues, currency risks, or continued American political instability could weigh down success. Business competitors like Oracle or Microsoft may perform better than IBM, or other software companies may enter competitively into the business software industry.

Conclusion and Valuation

IBM has been around for more than 100 years. It has remained dominant even as technology has changed at a rapid pace. This is no guarantee of future success, however. Over the last several years, IBM has transformed itself to focus more on software, more on services, and more on high-margin hardware, which I believe most people consider to be a wise move.

Overall, I think IBM is a reasonable buy at the current price of $190 for those who want exposure to large cap technology in their portfolio. Unfortunately the dividend yield isn’t very rewarding. I’d prefer it if the payout ratio and dividend yield were doubled to over 50% and 3% respectively. Still, if one invests in IBM for a total return perspective rather than a dividend perspective, the risk-adjusted rewards may be reasonable over time.

Full Disclosure: I have no position in IBM at the time of this writing. Like many companies, IBM is on my watch list. I own shares of Microsoft.
You can see my dividend portfolio here.

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Comments

  1. Hey,

    Good analysis, but one question; Have you ever tought that considering only 5-year span of revenue/eps/div etc. analysis isn’t sufficient enough considering exceptional situation of economy? Just wishing to hear your toughts or is it just that taking like ~10-span would be too time consuming?

    • Yes, it’s a matter of time consumption. For me to provide 40 or so of these analysis articles per year to sufficiently cover a reasonable portion of the well-followed dividend payers out there, I have to keep things reasonable.

      A lot of stock analysis articles I encounter online mostly just provide numbers. But numbers are easy to look up. So I provide numbers, but also include a significant thesis section to make the content more substantial. An article like this takes a few hours to write and proof-read.

      When I write the analysis or invest my money, I do indeed look back more than 5 years. And when there are aspects of those numbers that I consider to be important, I’ll include those references in the analysis itself. For instance, I discussed some actions in this article that IBM has taken over the past decade, not just the last five years. For other companies that had a huge rebound in profits since the recession, I often mention that sort of thing and discuss the sustainability of their current EPS growth, and so forth.

      Articles of this nature are meant to be a starting point. If one of these generates enough interest in the company, a potential investor should fact-check things and do more research.

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