International Business Machines (IBM -0.26%) is making its most significant structural change in years. The company announced it would spin off its managed infrastructure services businesses, effectively splitting the company into two separate tech stocks. IBM shareholders will hold a stake in IBM and receive shares of "NewCo," the temporary name for the new company, in the split.
However, as the remainder of IBM and the IT infrastructure company go their separate ways, it could produce benefits for both new entities and their shareholders.
Let's take a closer look at these three advantages.
1. IBM becomes more of a cloud company
With the purchase of Red Hat and the coming spinoff of the managed infrastructure services business, IBM becomes more of a cloud company.
Once IBM completes the spinoff, cloud and cognitive software becomes the company's largest revenue producer. Investors should recall that CEO Arvind Krishna ran cloud and cognitive software before taking the CEO job. He was also the driving force behind the Red Hat purchase while the current executive chairman, Ginni Rometty, served as CEO.
Fortunately, the Red Hat acquisition appears successful. Cloud revenue grew by 5% in the second quarter of 2019. By the second quarter of 2020, the cloud revenue growth rate increased to 30%. IBM has achieved this by succeeding with its hybrid cloud product, which it calls "a $1 trillion opportunity."
Nonetheless, with overall company revenue still falling, IBM has struggled to gain investor interest despite its successes in the cloud. Now, with the spinoff, the company can more easily achieve the mid-single-digit revenue growth target it has set over the medium term.
2. A second chance for managed infrastructure services
Spinning off this business will leave NewCo with $19 billion in annual revenue and about 90,000 employees. IBM currently employs more than 350,000 people.
IBM calls NewCo "the world's leading managed infrastructure services company." It also claims a $60 billion services backlog.
Nonetheless, NewCo has not prospered recently under the IBM umbrella. In the most recent quarter, global technology services, the division that controls managed infrastructure services, was the company's largest revenue driver at more than $6.6 billion. Still, this was a 7.6% decline from the same quarter last year. It also declined in the previous year.
Given this drop, some might wonder whether NewCo will remain a worthwhile investment. Time will tell. However, it will have a management team that can focus exclusively on improving managed infrastructure services.
3. Making it work for shareholders
Indeed, those investors long on IBM stock could use some relief. IBM's all-time high is just under $216 per share. Unfortunately for longs, this high came in the spring of 2013! Since that time, the stock has seen a secular bear market. Even at the current price, IBM sells at more than 40% below that peak.
Nonetheless, investors appeared to view the move favorably. The stock spiked higher by as much as 10% when IBM announced the spinoff, though it pulled back afterward.
Moreover, dividend investors will probably continue to benefit. The current dividend of $6.52 per share yields about 5.1%. The company achieved Dividend Aristocrat status this year with 25 years of consecutive increases, and IBM produces sufficient cash flow to continue the payout hikes. Furthermore, the spinoff will not negate the Dividend Aristocrat status for either company, as long as both companies continue annual payout hikes.
Despite these benefits, both companies will have to contend with a massive debt burden. Due primarily to the Red Hat purchase, the long-term debt had ballooned above $58.4 billion by the second quarter of 2019. This was a significant burden for a company with just over $17.6 billion in stockholders' equity.
Now, with debt at more than $54.4 billion, long-term debt remains elevated. However, both companies could find it easier to tackle their combined debt as separate entities.
Inevitably, some investors will wonder if the spinoff benefits IBM shareholders. The best news for stockholders is that such splits tend to lead to the sum of the parts becoming worth more than the whole. This way, IBM can center itself around its high-growth cloud services, and managed infrastructure services can singularly focus on yielding positive revenue growth from its $60 billion backlog. Long term, this could help bring long-overdue moves higher for both NewCo and the remainder of IBM.