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How Sustainable is IBM's Dividend?

By Leo Sun - May 10, 2017 at 6:55PM

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Is Big Blue still a worthy income investment after underperforming the market for years?

There isn't much positive news about IBM ( IBM 1.16% ) these days. Most recent headlines focus on Big Blue's 20th straight quarter of year-over-year sales declines or Warren Buffett's recent decision to sell about 30% of his shares. The stock has shed over a fourth of its value over the past five years -- a period in which the S&P 500 surged 75%.

But one key strength which keeps investors coming back is IBM's forward dividend yield of 3.9%, which is nearly double the S&P 500's current yield of 2%. That high yield, combined with a low P/E of 13 (compared to its industry average of 19), makes Big Blue look like a solid income play at current levels despite its lackluster growth.

A businessman waters a "money tree".

Image source: Getty Images.

But just how sustainable is IBM's dividend? To find out, let's examine the history of that dividend, its payout ratios, and the bottom line challenges Big Blue will face in the future.

Not a dividend aristocrat... yet

When a company raises its dividend annually for 25 straight years, it becomes an elite "dividend aristocrat", one of a group of stocks often favored by income investors. IBM is approaching that threshold with 22 straight years of dividend hikes. The company has also continually paid out dividends annually for over a century -- so that dividend won't fade away anytime soon.

Payout ratios

The easiest way to see if a company's dividend is sustainable is to check its payout ratio -- the percentage of its earnings or free cash flow which is spent on dividends. If either of those figures exceeds 100%, the dividend will likely be cut.

Over the past year, IBM spent 46% of its earnings and 47% of its free cash flow on dividends. Those low figures indicate that it still has plenty of room to raise its dividends. However, investors should still keep a close eye on IBM's cash flow -- which has been declining over the past few years due to its slowing growth and growing dependence on acquisitions.

IBM Free Cash Flow (TTM) Chart

Source: YCharts

Revenue and earnings growth

IBM's top line growth has slowed down due to sluggish demand for its aging IT services, hardware, and software products. The company is trying to offset that slowdown by expanding five "strategic imperatives" (cloud, mobile, analytics, security, and social), but that growth still isn't strong enough to give Big Blue a top line gain. That's why Wall Street still expects IBM's revenue to drop 2% this year and stay roughly flat next year.

IBM's bottom line growth looks slightly better, due to buybacks, divestments of lower-margin businesses, various cost cutting strategies, and layoffs. As a result, analysts expect its earnings to improve 1% this year and 2% next year.

The catalysts and challenges

Looking ahead, IBM hopes that newer cloud-based services -- like the Watson AI platform and BlueMix cloud platform -- will help it catch up to public cloud platform leaders like Amazon's ( AMZN 0.88% ) AWS (Amazon Web Services) and Microsoft's ( MSFT 1.45% ) Azure.

Amazon's AWS is the 800-pound gorilla in that market, with an annual run rate of nearly $15 billion. Microsoft doesn't disclose its exact revenue figures for Azure, but it reported that sales nearly doubled annually last quarter. Microsoft's total commercial cloud revenue (including SaaS products like Office 365 and Dynamics CRM) reached a run rate of over $15 billion at the end of the that quarter.

IBM claimed that its total cloud revenues (including public, hybrid, and private solutions) reached an annual run rate of $14.6 billion last quarter. It also noted that its strategic imperatives revenue accounted for 42% of its top line over the past 12 months. But as I already mentioned, that growth simply isn't enough to offset its weaker businesses yet. As a result, many analysts expect IBM to make additional acquisitions to strengthen those businesses as it divests weaker ones.

So how sustainable is Big Blue's dividend?

IBM's growth might remain stagnant for at least another two years, but I believe that its steady earnings growth and low payout ratios still make it a very dependable income play for long-term investors. The stock's weak performance over the past few years is worrisome, but its low P/E should set a floor under the stock until the company's multi-year turnaround finally bears fruit.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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