Is International Business Machines Corporation a Buy?

IBM trades at low valuation multiples and offers a big dividend yield. Should investors jump in?

Keith Noonan
Keith Noonan
Apr 4, 2018 at 9:17AM
Technology and Telecom

International Business Machines (NYSE:IBM) has missed out on the market's momentum over the last five years, and not without cause. The company's legacy hardware and software businesses have been in decline, weighing on sales and casting doubt on the company's future. Revenue is down roughly 22% over the last five years, and the weakening of its hardware and services segments has prompted the company to pivot to a range of cloud-focused businesses to move the company in a new direction. 

With shares trading at roughly 11 times forward earnings and 12 times expected free cash flow, I think IBM is a worthwhile idea for investors. Underappreciated turnaround prospects and a fantastic returned-income profile create the potential for the stock to do big things over time.

IBM's logo.

Image source: IBM. 

Returning big value to shareholders

IBM's dividend is one of the most compelling reasons to own the stock. The company offers one of the better payouts in the tech sector, with shares yielding roughly 3.9% at current prices. It's also built a dependable history of dividend growth, raising its payout annually for 23 years and generating enough cash to keep the increases coming. The cost of its dividend represented just 42% of IBM's free cash flow for 2017, suggesting that the company could continue to deliver dividend growth even if its business hits rough patches on its road to reinvention.

Big Blue is also conducting an ongoing share repurchase initiative, having reduced its outstanding share count by 16.9% over the last five years. It still has authorization to buy back another $3.8 billion in stock. That should lend additional momentum on the earnings front and free up the company to deliver greater dividend growth down the line.

IBM has a great history of returning value to shareholders. Some might argue that it's pursued that priority to a fault and that this caused the company to miss out on big tech trends like mobile. However, it seems like the company is currently striking a good balance between returning income and investing in the future of the business. 

How's the turnaround progressing?

The company's systems segment -- which includes systems hardware and operating systems software -- bounced back in the fourth quarter, with revenue up roughly 30% compared to the prior year due to sales from its Z mainframe line. The mainframe category is cyclical, and it's certainly welcome to have the business on an uptrend, but over the long term, the hardware segment will probably continue to decline. 

IBM's future is hitched to cloud services, analytics, security, and mobile -- a selection of businesses it groups under the banner of "strategic imperatives." 2017 saw this segment grow sales 11% year over year to $36.5 billion, or 46% of overall revenue. Cloud revenue for the period climbed 24% to $17 billion, with the as-a-service component of that rising 18% to $10.3 billion.

IBM is showing solid, if not spectacular progress and has the potential to leverage its enterprise credentials to keep growing its private and hybrid cloud services. That's where bets on technologies like blockchain, quantum computing, and its Watson artificial intelligence system will come into play. IBM appears to be making smart investments in areas that will shape cloud security and analytics, and, if it can leverage competitive advantages from them, it stands a good chance of overcoming declines elsewhere in the business.

The company is guiding for sales growth in 2018, which would be the company's first year of sales growth since 2013. However, it's also expecting free cash flow to come in roughly $1 billion short of 2017's total due to increased capital expenditures and a $600 million tax hit. That still puts projected FCF for this year at roughly $12 billion -- nothing to sneeze at even if it's below the $14.9 billion in FCF that the company clocked five years ago. 

Despite the long-term weakening of its systems segment and the costs associated with pivoting to cloud services, IBM is still a high-margin business that produces ample free cash flow. The company anticipates margin improvement as it continues to scale its cloud business. That could be disrupted by competition and other factors, but, for now, IBM appears to be positioned to continue delivering healthy cash flow.

An solid income play in tech

Rapid sales and earnings growth and big opportunities in the tech sector have elevated valuations, making value plays in the space harder to find. IBM's comparably sluggish performance in recent years isn't something to celebrate, and the company needs to overcome substantial challenges before it can claim a successful turnaround, but I think the tough stretches have also led to an opportunity for long-term investors.

There are signs that Big Blue's reinvention effort is moving in the right direction, and its low earnings multiples and great dividend do a lot to round out a comeback story that's worth having a stake in. With these factors in mind, I think IBM is a buy.