I've been using Verizon Communications (VZ 0.05%) stock as a fixed-income replacement for some years. It's a stable business and shares currently pay an annual yield of about 4.5%. However, lackluster results in the 5G era, a floundering media business the company should never have acquired (remnants of AOL and Yahoo!), and a fast-growing T-Mobile US encroaching on Verizon's turf have made me rethink my position. As a replacement, I've settled on International Business Machines (IBM 2.19%). Here's why.
Will the new IBM please stand up?
Like anyone else, I love a great deal, but sometimes, buying a "cheap" stock comes with hidden costs later on. IBM has long appeared to be an inexpensive stock but for good reason: Its legacy business lines have struggled for years. The acquisition of Red Hat was a game changer back in 2019, but the company was still dogged by declining businesses elsewhere. Over the last three years, IBM's total return (stock price plus dividends) has been negative 12%. Verizon, by contrast, has delivered a modest 31% total return over that same period.
But I think the tides are turning. Verizon's business carries a lot of debt (it costs a lot of money to build and maintain a mobile network, and those media assets added to the burden), and T-Mobile has been making real headway against its larger rival using next-gen 5G mobile service. Mobility is now a basic staple, not a growth industry. Meanwhile, IBM has been making some dramatic moves to narrow its focus on cloud computing, and new CEO Arvind Krishna has changed my mind about the company. It will be completing a spinoff of its managed infrastructure business by the end of this year -- not a total separation from its legacy operations but a sizable portion of the areas that have been a drag on IBM.
Peeling off this layer will leave the new entity a more focused enterprise on what it describes as "the $1 trillion hybrid cloud opportunity" -- helping its customers stitch together and update all of their various network assets. For reference, IBM's total cloud revenue increased 19% in 2020 to $25.1 billion. With what's leftover more concentrated on this fast-growing segment of the tech industry, I think the new IBM will return to growth mode next year. And valued at just seven times trailing 12-month free cash flow while currently sporting a dividend yield of 5.5% (a payout handily covered by free cash flow), the stock was just too cheap for me to ignore.
Cheaper than Verizon with real growth catalysts brewing
Rather than pity IBM as a tech has-been that can never quite get up to speed with the times, I think it's time to start thinking about IBM as a real leader in emerging tech trends like hybrid cloud computing and artificial intelligence (as a developer of AI applications and as a partner in helping organizations get the most out of their data). As Daniel Hernandez, IBM's general manager of data and AI, recently explained to me, the company is a critical partner for many organizations making use of public clouds like Amazon Web Services and Microsoft Azure, while simultaneously updating its own network assets for this new cloud-first era. And with its capabilities as a platform for building and deploying applications, this could be a powerful mid-market player that helps bridge the gap between high-tech and everyday use for the masses.
Verizon, by contrast, has no secret weapon lurking beneath the surface to help it return to robust growth. Its dividend is also handily covered by free cash flow, but I'm just not seeing any growth opportunities on the horizon for the mobile industry leader. Instead, I'm seeing growing threats from peers like T-Mobile that are willing and able to undercut it on price, as well as disruption from cloud companies that are helping migrate communications to the web. And trading at 11 times trailing 12-month free cash flow, it's also more "expensive" than IBM at the moment.
Granted, my thesis here is based on IBM spinning off some of its legacy businesses so it can effectively refocus on cloud and AI. But that plan is seemingly well under way, and I view its impact as going largely unnoticed by investors thus far. For the record, I still think Verizon is a quality dividend stock, but with limited room in the portfolio I manage, I like IBM even more at this juncture.