Stock returns can happen fast when narratives change. International Business Machines (IBM) (IBM -1.05%) languished for years as a dinosaur technology company struggling to find its footing in a cloud-driven market.
After declining steadily for the past decade, IBM has come alive due to its potential with artificial intelligence (AI). Shares are up 36% over the past year alone. There is legitimacy to IBM's revival, but investors must be careful not to overpay because there might be more hype than substance.
Is that the case for IBM today? Let's look at how AI affects IBM right now and gauge just how good IBM stock might be to buy.
AI growth is sparking IBM's business
Once a technology titan, IBM was left behind when the arrival of the cloud disrupted its legacy enterprise hardware business. It's reinvented itself over the years, becoming a mixture of hardware, software, and consulting solutions, but it's struggled to grow consistently. It shed its IT infrastructure services business in 2021, spinning it off as Kyndryl, and that's helping IBM start to grow again.
IBM Revenue (TTM) data by YCharts
Now, IBM believes artificial intelligence can carry the torch for future revenue growth. During its fourth-quarter earnings report, management commented that bookings for Watsonx and generating AI roughly doubled in the three months from the third quarter to Q4. That sounds encouraging. IBM grew revenue by 2% in 2023 over 2022, and 2024 guidance calls for accelerating to mid-single-digit revenue growth companywide. This evidence supports the assertion that IBM is seeing a notable uptick in its business.
This is excellent news for the company, but investors should be careful not to get too excited. After all, mid-single-digit revenue growth doesn't exactly scream hyper-growth stock that investors should unquestioningly pay anything for.
So, let's look at IBM's financial big picture.
IBM isn't a growth stock, so don't treat it like one
Just because IBM is growing doesn't necessarily make it a growth stock. The company's financials will show that IBM is anything but a high-growth investment opportunity. AI potential has excited analysts enough to raise their long-term earnings growth estimates. Boosting estimates from 5% to 6.7% is a significant uptick percentage-wise, but from a numbers standpoint, it is not that big a difference from where it was.
Additionally, the company is deeply in debt thanks to continual acquisitions and spending. There is roughly 3.8 times more long-term debt on the balance sheet than IBM's EBITDA, which is a ratio I generally like to see under 2.5. Then, factor in IBM's commitment to the dividend, which shows up in its 28-year streak of consecutive dividend raises. The dividend costs roughly $6 billion, half of IBM's guided free cash flow for 2024.
IBM EPS LT Growth Estimates data by YCharts
This isn't meant to be a put-down of IBM, but investors need to see a company for what it is. IBM is a fine dividend stock. The dividend yield is 3.5% today, and there's enough growth to fund more increases, while the $6 billion in leftover cash flow can help management repurchase shares or pay down debt. It doesn't do investors any good to try to paint the company as something it's not, especially in the face of broader AI excitement. This is not another Nvidia.
Is IBM a buy?
As a dividend stock, paying a reasonable valuation is even more crucial. A severe overpayment can create years of poor returns while the underlying business catches up to the stock's price tag.
IBM's big rally over the past year has bumped the valuation from a forward price-to-earnings (P/E) ratio of 14 to over 18. Is 18 times earnings a good price to pay for the stock? It may not be if IBM can't outperform analysts' projected 6% to 7% earnings growth estimates. That's a price/earnings-to-growth (PEG) ratio of roughly 3, which is about double the ratio I prefer.
Again, IBM is a fine dividend stock, and the accelerating revenue growth in 2024 is encouraging. But investors looking for total returns may have missed the big move. Of course, the stock could keep going up, but it's getting hard to like its chances of solid returns.
