IBM – Should I bet on Hybrid Cloud Growth!

IBM has been part of my portfolio since I was following the Dividend Growth Investors newsletter nearly 3 years ago.  At first glance, it is easy to see why Investors following a DGI strategy would be drawn to IBM. The company has increased its dividend for the last 25 years, the FCF payout ratio is below 50% and they have a historically high dividend.

However, they have fallen out of favor with some Investors and even featured on Dividend Talk episode 32 recently.

I have had discussions with both the Sunday Investor and Charles from Financial freedom is a journey about my screening process. As a beginner investor, I think it is wise to have a clear set of rules to help you select companies to complete your due diligence. While you will likely miss out on some quality companies such as Stryker (Which I recently reviewed on Charles’s website) you should hopefully miss companies that are in decline.

A sustainable and growing dividend is the foundation of my Dividend Growth Strategy. I also want my portfolio full of Quality companies like Microsoft, Unilever, and Johnson and Johnson. Companies that I can invest and forget about for the next decade and know that my money is “safe”.

While I am evaluating my portfolio, It seems like a good time to deep dive into IBM a little bit. Do they deserve a place in my portfolio or is it time to give them the boot like Coca-Cola?

Company Introduction

IBM is a global supplier of technology, software, and systems hardware. The company offers many products and services such as AI, Blockchain, Business Operations, cloud computing, Data & Analytics, and IT infrastructure to name a few. It is quite easy to get overwhelmed as an investor by the amount of choice that IBM offer.

In 2016, IBM changed its segment reporting to reflect the company’s shift away from being a hardware, software, and services company, and towards becoming a cognitive solutions and cloud platform company. From page 1 on the 2020 10-K, IBM has the following business segments:

1. Cloud & Cognitive Software,
2. Global Business Services,
3. Global Technology Services,
4. Systems,
5. Global Financing.

To help accelerate its hybrid cloud growth strategy, IBM announced in October 2020 that they will separate its Managed infrastructure services unit into a new public company. The spin-off is not yet named but is set to formally become an independent company by the end of 2021.

IBM Growth

On January 21st, 2021, IBM reported Q4 and FY2020 results

A quick look at the full-year highlights shows:

1. EPS was down 29% from 2019
2. Revenue declined 5%
3. FCF was $10.8 bln which more than covered the dividend
4. Cash on hand was $14.3 bn
5. They reduced debt by over  $11 bln since closing the Red Hat Deal

Giving the year that most companies have had this does not look so bad. The company also released slightly optimistic expectations for 2021 where the expectation is to grow their top line and increase the FCF.

“The company expects to grow revenue for the full year 2021 based on the current 
foreign exchange rates. The company also expects adjusted free cash flow of $11
billion to $12 billion in 2021.”
 

Rather than look at one year in isolation, I prefer to check the financial statements over the last 5 and 10 years to see if I can spot any trends. I will also look for some catalysts to see if there are any growth prospects for the company over the next couple of years.

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IBM Income Statement analysis

IBM’s market cap is currently ~$115B and its book-value-per-share is ~$23.08. Revenue has declined from $99.8B in FY2010 to $73.62B in FY2020 for a ~ -3% compound annual growth rate (CAGR).

During the same timeframe, (GAAP) EPS declined from $11.52 to $6.18 which is a CAGR of -6.11%. Diluted EPS were growing from 2010 until 2016 before a huge decline in 2017. The effective income tax rate for 2017 was 49.5% which included the impact of complying with the Tax Cuts and Jobs Act signed into law in December 2017. This resulted in a one-off charge of $5.5 billion in the fourth quarter. In truth, IBMs aggressive and absurd share repurchase program helped steady EPS while revenue was declining up until 2018. I would highly recommend reading this article on why IBM did not make good use of its share Buybacks.

Since 2019, after the acquisition of Red hat, share buybacks were sensibly canceled in favor of paying down debt.

Operating Margin is a profitability indicator that reflects operating income relative to Net Revenue. A strong operating margin is essential to service fixed costs and debt. IBMs’ FY2020 Operating Margin deteriorated to 11.70% versus 14.00% in FY2019. Operating expenses have been relatively stable over the past 10 years which points to the decline in operating margin towards the drop in net revenue.

IBMs’ 48.3% Gross Profit Margin is pretty much on par with the 10-year average of  48%. According to Ready Ratios, IBM profit margins are better than the average Gross profit margin for the companies peers which is 34.8%

IBM Balance Sheet

Goodwill

In FY2020, Goodwill, Other Net Intangible Assets amount to ~$73.41B of $155.97B of Total Assets; this is ~47.3% of Total Assets. Based on 893 million FY2020 weighted-average shares outstanding, and $82.56B of ‘hard assets’ (exclude ~$73.41B of the aforementioned ‘soft assets’), we get a tangible book value of ~-$59.17.

Quite often, a company acquires another company and pays a price exceeding the acquired company’s tangible book value. The acquiring company reflects the difference between the purchase price and tangible book value of the acquired company on its balance sheet as “Goodwill”. When the ‘Goodwill’ component of a company’s Balance Sheet increases over time, it is a signal that the company is in acquisition mode.

The Goodwill/Total Assets ratio amounted to ~38% in FY2020 versus ~23% in FY2011. We can see IBMs’ acquisition history has been significant in recent years. Since 2021 the company has made 185 acquisitions at a total cost of $87.2 billion. The most notable is the recent acquisition of Red Hat for $35 billion.

Debt analysis

Looking at IBMs’ FY2020 Balance Sheet, we see a Total Long term debt of ~$54.15 versus Total Shareholder Equity of ~$20.726. This gives us a Total Long term Debt/Equity ratio of ~262%.

When this ratio exceeds 1, I check the interest coverage and the Net Debt/ EBITDA. Interest coverage determines the extent to which a company can service the interest on its outstanding debts. The Net Debt/ EBITDA ratio reflects the time a company needs to operate at its current Net Debt/EBITDA level to pay all its debt. I typically like to see an interest coverage ratio above 4 and a Net Debt/ EBITDA ratio below 3. Interest Coverage is currently above 6.7 and the Net Debt/ EBITDA is 3.04.

While none of these metrics meet my criteria, they are pretty close. Prior to the Red hat acquisition, Intrest coverage was above 18 and Net Debt/ EBITDA was below 2 so it makes sense that the company has foregone buying back shares in favor of paying down its debt.

I would rate IBMs’ balance sheet as acceptable and would like to see them continue to pay down debt over the next few years.

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IBM Risk Assessment

On July 9, 2019, Moody’s downgraded IBM’s unsecured rating to A2 from A1 following receipt of regulatory approval for IBM to acquire Red Hat, Inc with a stable outlook.

The A2 rating reflects the company’s strong business model, large scale, consistent free cash flow generation, customer and geographic diversity, as well as its strong liquidity

With over $6 billion of projected free cash flow after dividends, share repurchase suspension for 2.5 years post-closing, and plans to aggressively repay debt, Moody’s expects leverage will approach the low 2x by 2023.

Moody’s rating is the top tier of the ‘Upper Medium Grade’ which meets my criteria.

Dividend Quality

I typically prefer companies with a starting yield at least 1.5 times the ~1.48% average S&P 500 dividend yield as of March 17, 2021. Naturally, there are always exceptions and I am willing to consider a lower starting yield if the dividend growth is sufficient.

With shares trading at ~$136 and a $6.52 annual dividend, IBM’s dividend yield is ~4.78%. Historically, this is higher than the average 1.93% yield. While the yield is quite high, we can see from our analysis of the income statement and balance sheet that debt has increased while revenue and profit margins have reduced. I guess these risks are “priced” into the market at the moment.

Part of my Investment thesis is to invest in companies that show a good history of increasing dividends and good growth potential. Companies that generate sustainable earnings growth often make the best dividend companies as it is easier to raise the dividend when earnings are rising.

IBM has been paying dividends since 1913 and has increased the dividend for the last 25 years. While the 10 year dividend growth rate is just above 10% , The dividend growth rate has been declining over the last 5 years. The last dividend raise was a disappointing 0.6% which is well below the 6% that I like to see.

In the FY2011 – FY2020 timeframe, IBM has generated the following Free Cash Flow (FCF): $15.73B, $15.504B,$13.862B, $13.128B, $13.676B, $13.517B, $13.495B, $11.852B, $12.484B and $15.579B. This is a ~0.14% CAGR.

During the same period, Stryker’s annual dividend amounted to: $2.90, $3.30, $3.70, $4.25, $5.00, $5.50, $5.90, $6.21, $6.43, and $6.51. This is a ~10.04% CAGR.

The Payout Ratio is a good indicator of the sustainability of dividends. As a European Dividend Investor, I am used to a conservative rate below 50%. However, for US companies I like anything under 70%. IBMs typical dividend/FCF is ~30% – 50% with a ~35% 10-year average.

When the dividend growth rate exceeds the FCF growth rate, I become somewhat concerned. In IBM’s case, however, the FCF payout ratio is so low my concern is alleviated.

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Future Growth

There is no doubt that the last decade has been a struggle for IBM. The only real highlight has been the acquisition of Red Hat for $34 Billion. Current CEO Arvind Krishna who was head of IBM’s cloud and cognitive software division at that time spearheaded this acquisition. This was really the beginning of IBM’s transition into the hybrid cloud market.

In October 2020, IBM’s proposed a tax-free spinoff of its managed infrastructure services business to existing IBM shareholders. This will allow the company to focus on Cloud and Cognitive Software, Global Business Services, Systems, and Global Financing segments and the spin-off (NewCo) will focus on managing and modernizing client-owned infrastructures that will comprise the Managed Infrastructure Services business.

On the dividend front, IBM will lose its short dividend aristocrat status as the expected quarterly dividend paid by both the entities combined will not be lower than IBM’s pre-spin dividend per share. When the separation is fully complete, the board of directors for each entity will determine the dividend policy.

I believe it makes sense for CEO Arvind to spin-offs the companies legacy business which is shirking and has low margins. The question remains if it is too late for them to compete with Amazon‘s AWS and Microsoft‘s Azure. IBM has seen double-digit growth in cloud growth in 3 of the last 4 quarters, however, this includes cloud-enabled products like cognitive services and consulting revenue from its Global Business Services and Global Technology Services units. This makes it difficult to try and estimate numbers compared to both Microsoft and Amazon.

According to Statista IBM cloud has a 5% market share which is around $6.5 Billion and IBM have estimated that will grow at 5% per year.

You will find more infographics at Statista

Valuation

I found it incredibly hard to give an estimate for a fair valuation for IBM until we see what life is like post-split. The Valuation techniques that I use, mainly the Dividend Discount Model and the Discount Cash Flow involve using some assumptions but honestly, there is so much uncertainty with IBM that I can’t make a solid estimation at the moment.

According to Y-Charts the average PE ratio over the last 5 years was 15.7. Using the current earnings of $6.30, IBM’s current valuation pre-split would be $98. This is a crude method but probably my best guess at this moment.

Conclusion

Over the last decade, IBM’s performance has been underwhelming especially when you consider how tech stocks, in general, have grown. As a Dividend Growth Investor, positives can be taken from the Dividend Growth over the last 10 years and the free cash flow generation that IBM created. With that said, I do not consider myself a short-term investor and I need to see some catalysts over the next 5 to 10 years.

I don’t envy the job of CEO Arvind Krishna. He took over from Ginni Rometty whose legacy includes her huge pay packets and bonuses despite the companies poor performance. While the spin-off is certainly a step in the right direction,is it enough?

Giving the past performance and uncertainties going forward, I will prefer to sit on the side-lines and wait for signs of hope. I don’t see enough of a catalyst going forward and prefer to see the company start to grow its top and bottom line before investing any more money. In fact I will be selling my shares in the company and adding them to my watchlist going forward as I feel there are better oppurtunies in the market.

Disclosure: Derek has a position in IBM and has no plan to initiate a position in the next 72 hours

If you would like a copy of the template I use to perform fundamental analysis then feel free to grab your copy below. I explain how I use the template here!

[convertkit form=1933300]

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