The stock market doesn't quite know what to do with International Business Machines (IBM -1.05%). Shares of the century-old tech company have been treading water since before the pandemic. As of July 10, IBM stock is just a few percentage points off from where it traded five years ago.
A lot has changed in those five years, though. Notably, IBM poured $34 billion into the acquisition of Red Hat to boost its hybrid cloud business, and it spun off its slow-growing, low-margin managed infrastructure services business. The IBM of today is starkly different than the IBM of five years ago.
These moves, part of IBM's decade-long transformation effort, have made the company simpler and more focused. Revenue growth has returned, and free cash flow is on the rise. Even in a tough economy, the critical products and services IBM sells to its enterprise client base are in high demand.
Through it all, IBM has maintained its impressive dividend streak. The company has paid quarterly dividends without fail since 1916, and it's increased its dividend annually for 28 consecutive years. The most recent quarterly dividend of $1.66 per share works out to a dividend yield of 5%.
A simpler company
IBM is still a mix of legacy businesses and newer businesses, but the company is now much more aligned with its best growth opportunities.
Three-quarters of IBM's revenue now comes from software and consulting, and more than half of revenue is recurring in nature. In the software segment, IBM has diversified away from transaction processing software. Most of IBM's software revenue now comes from security, data analytics, artificial intelligence, automation, and hybrid cloud solutions.
Red Hat's OpenShift hybrid cloud platform has reached a $1 billion annual recurring revenue run rate, while total non-transaction processing software has reached a $13.5 billion annual recurring revenue run rate. Software is the highest-margin part of IBM, with the segment generating pre-tax income of $1.2 billion on revenue of $5.9 billion in the first quarter of 2023.
Consulting is less profitable, but it ties in nicely with the software business. IBM's consulting arm helps clients navigate digital transformations and adopt cloud-based infrastructures, which drives some revenue to IBM's software and hardware businesses. Consulting generated $5.0 billion of revenue in the first quarter, along with $0.4 billion of pre-tax income.
The infrastructure segment, which includes hardware and support, is the smallest revenue contributor, but it's still important for IBM. Financial institutions and a wide array of other large organizations still rely on IBM's mainframe systems, and that's unlikely to change anytime soon. IBM's latest mainframe systems can be integrated into a hybrid cloud infrastructure, and mainframe sales drive additional sales of software and services.
Growth, free cash flow, and the dividend
IBM has struggled to grow over the past decade, but that's now changing. The company expects to produce revenue growth between 3% and 5% this year, excluding the impact of currency; not a bad result, given the current economic environment. Many of IBM's products and services are ultimately aimed at saving clients money or improving productivity, both of which should play well when cost-cutting is the order of the day.
Free cash flow is also improving, thanks in part to the high-margin software business. IBM expects to generate $10.5 billion of free cash flow this year, up more than $1 billion compared to 2022. With a market capitalization of $120 billion, the stock trades for less than 12 times free cash flow.
This free cash flow easily supports IBM's dividend, although the dividend isn't going to grow much faster than free cash flow. The current quarterly dividend requires about $6.1 billion annually, based on the share count at the end of the first quarter. That leaves plenty left over for debt reduction and the occasional acquisition, like the recent $4.6 billion acquisition of Apptio.
To be fair, IBM stock has looked cheap for a long time. But the company is now in a good position to steadily grow its revenue and free cash flow over time. Eventually, the market will wise up and award IBM stock a valuation that isn't so pessimistic.
