IBM's (IBM +2.06%) stock recently plunged to its lowest point since 2009 as the novel coronavirus pandemic killed the bull market. However, that steep sell-off reduced its forward P/E ratio to less than 10 and boosted its forward yield to more than 6%.
That massive yield is tough to ignore, especially since Big Blue seemingly approached an inflection point earlier this year. Let's see why those tailwinds are still strong, and why IBM's low valuation and high yield should set a floor under its battered stock.
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How sustainable is IBM's dividend?
IBM has raised its dividend annually for 24 straight years. If it raises its dividend this year, it will become a Dividend Aristocrat -- a member of the S&P 500 index that has raised its payout for at least 25 straight years.
Over the past 12 months, IBM spent 48% of its free cash flow (FCF) and 61% of its earnings per share (EPS) on its dividends. Those low payout ratios indicate that IBM has plenty of room for future dividend hikes.
IBM's annual FCF stayed nearly flat at $11.9 billion in 2019. However, it expects its FCF to rise 5% to $12.5 billion in 2020 as its acquisition of Red Hat, the expansion of its hybrid cloud business, and rebounding system sales boost its total revenue 4% to 5%. It expects its non-GAAP operating EPS to grow 4% to $13.35, which would easily cover its annual dividend payments of $6.48 per share.
In short, IBM's dividend is easily sustainable, and its stable FCF and earnings growth suggest it will become a Dividend Aristocrat in 2020.
How stable is IBM's core business?
Over the past few years, IBM tried to offset the softness of its legacy business software, hardware, and IT services businesses with its higher-growth cloud services. It also dialed back its buybacks and deployed that cash on acquisitions of cloud-oriented companies like SoftLayer, Verizon's cloud unit, and Red Hat.
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IBM CEO Ginni Rometty, who led the tech giant since 2012, recently announced her resignation and handed the reins over to Arvind Krishna, the chief of IBM's Cloud and Cognitive Software unit.
The bulls hope Krishna, who takes over on April 6, will strengthen IBM's cloud services and help it compete more effectively against Amazon (AMZN 0.41%), Microsoft (MSFT +1.01%), Alphabet's (GOOG 0.15%) (GOOGL 0.57%) Google, along with others in the crowded market. The bears believe IBM will struggle to keep pace with those bigger rivals, and that its guidance -- which was posted in late January, before the coronavirus crisis intensified -- is too optimistic.
Last quarter, only two of IBM's core businesses -- cloud & cognitive software and systems -- posted annual revenue growth. Revenue from its other three business units (global technology services, global business services, and global financing) declined.
The road ahead
If the pandemic worsens, enterprise customers will likely postpone cloud, security, and IoT (Internet of Things) upgrades, as well as purchases of new mainframes. That slowdown would blow out IBM's main growth engines.
Red Hat, which grew its revenue 24% annually last quarter and accounted for 15% of IBM's cloud and cognitive software revenue, is also vulnerable to economic slowdowns. During the Great Recession, Red Hat's revenue growth slowed to 15% in fiscal 2010, compared to 25% growth in 2009 and 31% growth in 2008.
If Red Hat experiences a similar slowdown in 2020, IBM could struggle to hit its revenue and EPS targets. However, its payout ratios should stay at sustainable levels.
IBM remains an undervalued dividend stock
IBM's stock probably won't rally anytime soon. The novel coronavirus pandemic is striking IBM as it shifts gears, and Krishna must quickly prove that higher revenue from Red Hat, its cloud services, and mainframe unit can offset its weaknesses and generate sustainable growth.
That turnaround will take time, but I believe IBM's yield is too high to ignore. Investors looking for a future Dividend Aristocrat with limited downside potential should stick with Big Blue through these volatile times.
