Instead of delivering a forecasted sixth consecutive quarter of year-over-year revenue decline, International Business Machines (IBM -0.25%) posted revenue growth during the fourth quarter, and non-GAAP (adjusted) earnings per share (EPS) of $4.71 exceeded analysts' expectations by $0.02. In addition, thanks to the strength of the tech giant's cloud business, management predicted free cash flow to increase in 2020 and committed to raising the dividend. But despite these encouraging results, investors shouldn't expect more than a low-single-digit dividend hike.
The rise of cloud
IBM's fourth-quarter year-over-year revenue increase of 0.1% remains modest, but it represents an important change of trajectory. The company has been struggling over the last several years to offset the decline of its legacy businesses against the rise of cloud computing. Enterprises have been moving some of their applications and computing infrastructure from their premises to the cloud to focus on their core businesses and take advantage of the flexibility this technology offers.
In consequence, IBM's legacy hardware, software, and services such as consulting and outsourcing have become less relevant. As an illustration, IBM's global technology services, which consist of designing, implementing, and maintaining infrastructure and systems, declined 4% year over year because of ongoing transition to the cloud.
IBM has been adapting its business to this new way of consuming information technology over the last several years. But with its 109 years of history and its $77.1 billion of revenue in 2019, the company couldn't catch up with innovative emerging public cloud players such as Amazon.com's Amazon Web Services and Microsoft's Azure.
Thus, IBM acquired the growing open-source cloud company Red Hat in 2019 for $34 billion to accelerate its transition and focus on hybrid cloud offerings (flexible solutions that run on any combination of public and private cloud providers). This decision seems to keep up with its promises, so far.
Beyond the year-over-year revenue growth acceleration of Red Hat from 19% during the third quarter to 24% this quarter (at constant currency and normalized for comparability to historical performance), synergies with IBM's other businesses seem to have materialized. For instance, IBM's Cloud Pak solution takes advantage of Red Hat's OpenShift platform to allow customers to move their applications to any cloud in an efficient and secure way. Also, IBM is taking advantage of its large scale by implementing Red Hat solutions over its legacy customer base. During the last quarter, IBM doubled the number of Red Hat large deals (above $10 million) to 21.
As a result, cloud revenue increased to $6.8 billion during the fourth quarter, up 23% year over year, which represented 31.2% of the company's total revenue compared to only 4.4% in 2013.
Dividend increase vs. debt
With these strong results and given the tailwind IBM's cloud business represents, management indicated it would expect free cash flow to increase from $11.9 billion in 2019 to $12.5 billion in 2020. Besides, during the earnings call, CFO Jim Kavanaugh said the company would remain committed to increasing its dividend, which will put IBM in the list of Dividend Aristocrats.
Since IBM's annualized quarterly dividend of $5.6 billion represents less than half of the expected free cash flow in 2020, there's ample room for a strong dividend increase. But the company must focus on reducing its debt after it paid its $34 billion acquisition of Red Hat in cash, and Kavanaugh confirmed this will be the company's goal over the next couple of years.
Discussing IBM's debt remains tricky since the company also acts as a bank for some of its customers, lending them money to finance their projects. IBM's total debt amounted to $62.9 billion at the end of 2019. But even if you exclude these financing activities, which involve a debt of $24.7 billion, IBM's core debt of $38.2 billion remains high. In any case, IBM's total debt and core debt represent 5.0 times and 3.1 times its forecasted free cash flow, which remains significant.
But you should also take into account the current dividend will leave only $6.9 billion of cash in 2020 to reduce the debt. Thus, I expect the dividend hike management should announce by the end of April to remain modest.
Yet even after the increase in the stock price after these better-than-expected results, IBM's dividend yield of 4.66% remains attractive. And the non-GAAP EPS forecast of at least $13.45 corresponds to a low P/E ratio of 10.7.
Despite a possible disappointing dividend increase, dividend-oriented investors should consider IBM an interesting opportunity because of its low valuation. In addition, the growth potential of its cloud businesses should support a sustainable dividend over the long term.