As a result, IBM's stock now trades at its lowest price since 2009, and its other valuation metrics also make it, at least initially, appear like a bargain hunter's dream stock:
- Forward P/E Ratio: 8.2 (lowest in over 10 years)
- Dividend Yield: 5.4% (all-time high)
While the firm's dividend has historically been on very solid ground, our longtime readers know I've been an IBM bear for years. If you're interested, you can read the initial note I posted on the company in August 2015 here.
However, doing my best to put my biases aside, let's take a look at why the market is so bearish on Big Blue, if the dividend remains safe, and whether this high-yield stock appears to be a reasonable long-term investment with so much pessimism now priced in.
Earlier this year IBM investors were hoping that after 22 consecutive quarters of year-over-year revenue declines, the company had finally turned a corner. In the last three quarters before this one, IBM managed to post modest quarterly sales gains.
However, those quarters largely benefited from currency exchange rate tailwinds and the launch of the new Z14 mainframe server, which caused a temporary spike in sales.
IBM's short-lived revenue growth streak broke in the third quarter. The company reported flat sales growth, and -2% revenue growth after adjusting for currency fluctuations.
IBM is counting on continued double-digit sales growth from these businesses to offset its declining legacy hardware sales and ultimately restore it to positive top and bottom line growth.
- Q3 SI revenue growth: 7% (and down 8% from Q2 2018)
- Q3 Cloud revenue growth: 10% (Q2 growth was 20%)
This deceleration, which came despite a continued pickup in economic growth and IT spending, casts more doubt over whether Big Blue will be able to compete with larger and more dominant tech giants in the industries of the future. Regardless, for 2018 IBM is still guiding for:
- "at least" $13.80 per share adjusted EPS; flat compared to 2017
- $12 billion in free cash flow; -8% compared to 2017
IBM to Acquire Red Hat
On October 29, IBM announced it would acquire Red Hat for $34 billion, its largest-ever acquisition.
Red Hat has been in business for 25 years and essentially provides corporations with software they need to effectively manage their applications across their in-house data centers and with cloud providers such as Amazon (AMZN), Microsoft (MSFT), and IBM.
IBM claims that 80% of enterprise workloads have yet to migrate to the cloud. The idea is that many companies will opt to keep some of their computing on their own servers while migrating other programs to various cloud providers. Red Hat helps make that work easier for software developers.
Red Hat's business model is certainly appealing. Mature software companies are known for their impressive profitability and excellent cash flow generation. Red Hat sports an 85% gross margin, does business with 90% of the Fortune 500 companies, grew revenue nearly 20% over the past year, and has a free cash flow margin north of 20% (compared to IBM's 8%).
Thanks to Red Hat's impressive metrics, IBM expects the deal to boost its revenue growth by 200 basis points and improve its gross margin and cash flow per share in the first year after closing.
Of course, a company like this doesn't come cheap. IBM is paying over 10 times trailing sales and over 30 times free cash flow for Red Hat. If Red Hat doesn't continue its growth trajectory, or the hybrid cloud landscape shifts in a way management did not expect, shareholders will be regretting this risky deal.
On the other hand, IBM needed to do something. The company was losing in cloud and, based on its lackluster quarterly growth figures, wasn't showing enough signs of being able to start closing the gap with its major rivals.
Like with most things, it will take time to gauge how wise the Red Hat deal ultimately is. However, given the steep price tag and the risks involved, not to mention IBM's poor reputation of acquiring businesses only to ruin the cultures that made them successful, investors have fair reasons to remain skeptical of this strategic acquisition.
Regardless, what does IBM's acquisition of Red Hat mean for its dividend?
First, while IBM's free cash flow payout has increased significantly over the last decade, it remains at a reasonable level of 45% today. The company retains around $6 billion of free cash flow after paying dividends that can be used to reinvest in growth opportunities, maintain a strong balance sheet, make strategic acquisitions, and opportunistically repurchase shares.
Red Hat is expected to increase IBM's cash flow per share in year one, so the acquisition shouldn't pressure the company' payout ratio.
Simply put, despite IBM's growth struggles, its payout ratio does not suggest its dividend is in danger, especially given the firm's balance sheet.
Some companies with reasonable payout ratios will still cut their dividends if they feel a need to deleverage more quickly. That can be especially true following a large acquisition.
One of IBM's key strengths from a dividend safety perspective was its pristine balance sheet. Prior to the Red Hat deal, the company maintained conservative leverage ratios which earned it an 'A+' credit rating from Standard & Poor's. After the acquisition was announced, its credit rating was downgraded one notch.
Besides its conservative use of leverage, IBM's dividend safety profile was also bolstered by its healthy cash reserve. The firm held nearly $15 billion of cash compared to just $16.6 billion of non-financing debt and annual dividend payments of about $5.7 billion.
IBM will pay for Red Hat using a combination of cash and debt, which will weaken its balance sheet and debt ratios. Per Moody's estimates, "IBM's pro-forma gross adjusted debt to EBITDA will exceed 3x at closing, up from about 1.7x as of September 30, 2018."
While that's not necessarily a dangerous level of debt, it does raise the stakes. IBM's existing operations need to continue throwing off plenty of free cash flow like they do today to help the company deleverage over the next few years.
As we saw when reviewing IBM's free cash flow payout ratio, the good news is that the firm currently retains a healthy amount of cash flow after paying dividends (around $6 billion) to help reduce its debt load. Investors need to be sure that continues to remain the case in the years ahead.
To direct more of its retained cash flow to deleveraging, management also plans to suspend IBM's share repurchase program in 2020 and 2021:
“The company will continue with a disciplined financial policy and is committed to maintaining strong investment grade credit ratings. The company will target a leverage profile consistent wit ha mid to high single digit A credit rating. The company intends to suspend its share repurchase program in 2020 and 2021."
Management expects these actions to allow IBM to continue growing its dividend, albeit at a very moderate pace for the foreseeable future. Based on the information we know today, the company's expectation appears reasonable.
IBM's future growth is predicated on the continued growth of its strategic initiatives, which is ultimately tied to its cloud computing business.
While the company's 24% growth in cloud computing revenue over the past year is impressive, it's important to put that figure in context.
According to analyst firm Synergy Research, the cloud computing industry is growing about 50% per year. That means IBM is losing market share to dominant players like Amazon, Microsoft, Alphabet (GOOG), and Alibaba (BABA). All of these companies are reporting cloud growth of 50+%.
Why should investors care about cloud market share? Isn't IBM's double-digit cloud growth enough to make it a good investment?
This leads to better deep data analysis and more useful tools and applications for clients to maximize the profitability of their businesses. In addition, third-party software developers are more likely to develop new apps for the largest platforms, which means that market share matters a great deal.
And since IBM's long-term EPS and FCF per share guidance is predicated on achieving much stronger economies of scale (higher margins), market share is very important to the ultimate success or failure of its turnaround plan.
Back in 1993, the last time IBM was struggling with a major turnaround effort, it fired its CEO and the new one quickly cut the dividend. In fact, IBM ended up cutting its payout twice within three quarters, for a total reduction of 79%.
If Rometty is replaced by the board of directors IBM might end up announcing a major strategic shift that could once more call into question the safety of the dividend, especially if the firm's free cash flow generation has deteriorated.
In that context, it's not surprising to see IBM take a more drastic measure by making its largest-ever acquisition to become the leader in hybrid cloud computing.
While this isn't a "bet the firm" deal, it does weaken IBM's balance sheet, put more pressure on the firm to maintain its existing free cash flow stream, and create additional operational risk.
As a result of the firm's expected jump in financial leverage from the acquisition, IBM's Dividend Safety Score has been downgraded from 92 to 65, a level that is still "safe." The company's payout appears to remain on solid ground based on the information we know today, but it's not as safe as it was prior to the Red Hat acquisition.
As we stated in our February 2018 thesis, "Conservative dividend investors may be better off sticking with other companies that have clearer paths to profitable long-term growth and operate in markets with a slower pace of change."