The disappointments for IBM (NYSE:IBM) investors continue. In a year in which cloud computing has skyrocketed in importance because of the effects of the pandemic, the old tech giant's stock is down 12% year-to-date, weighted down by its stubbornly declining legacy businesses. But IBM has a plan in place to spin off nearly one-quarter of its revenue into a new business, leaving the new IBM focused on high-growth cloud computing.

And with the dividend yielding 5.2% a year in the meantime, this could finally be the value tech investors were looking for. 

An illustration of a cloud surrounded by computers.

Image source: Getty Images.

Another ho-hum quarter

IBM's Q3 2020 revenue fell 2.6% year-over-year to $17.6 billion, continuing the low-single-digit-percentage declines posted all year. However, old business lines like the Global Technology Services segment (which houses the managed infrastructure sales IBM is planning to offload into a new stand-alone business, currently dubbed NewCo until a name is settled on) are dragging down cloud computing strength. Management said total cloud revenue was $6.0 billion in the quarter, a 19% year-over-year increase, led by the Red Hat cloud app development and management acquisition in July 2019.

However, the good news is that as IBM replaces old revenue with new, its profit margins on services rendered are rising -- although net income is lower this year, as expenses related to the Red Hat takeover are still weighting it down. When it spins off the low-profit-margin NewCo by the end of next year -- Cloud and Cognitive Software gross margin was 77% and net pre-tax margin 22% in Q3, compared to 35% gross margin and 7% net pre-tax margin for the Global Technology Services segment -- what remains could be a top cloud computing tech play. 

Metric

Nine Months Ended September 30, 2020

Nine Months Ended September 30, 2019

Change

Total revenue

$53.3 billion

$55.4 billion

(3.8%)

Gross profit margin

47%

45.9%

1.1 pp

Net income

$4.23 billion

$5.76 billion

(27%)

Free cash flow

$4.75 billion

$5.88 billion

(19%)

Data source: IBM. Pp = percentage point.  

A cloud dividend champ in the making?

The other consideration here is IBM's large burden of debt, $65.4 billion at the end of Q3 (including $20.9 billion held in its Global Financing division, which provides lending and flexible payment options for IT hardware), offset by $15.8 billion in cash and equivalents. Depending on how it structures NewCo, the new IBM could also become a far more nimble operation with lower indebtedness. Paired with higher profit margins, that could enable the remaining cloud-centric enterprise led by Red Hat to double down on growth and pursue other acquisitions. 

Specific details on that remain to be seen, though, and in the meantime management continues to use its profitability to clean up the balance sheet. Some $4 billion to $5 billion in debt will be paid off or refinanced during the fourth quarter. And while free cash flow -- revenue less cash operating and capital expenses, a highly variable quarterly metric but an accurate measure of true profitability -- was only $1.1 billion in Q3, compared to $1.8 billion a year ago, and trailing 12-month free cash flow was $10.8 billion through the end of Q3 2020 compared to $12.3 billion a year ago.

For owners of the stock, this means that the high-yield dividend remains on solid footing, as dividend payments have cost IBM only $5.78 billion over the last 12 months, eating up just over half of free cash flow. Once spun off, NewCo and the new IBM will set their own respective independent dividend policies -- but while shareholders wait, the existing company is a top income generator. And once the new IBM, focused on the cloud, emerges, it looks like it could be a top cloud computing stock. I'm holding tight until more details are released, but IBM is now on my watch list.