IBM (NYSE:IBM) and Hewlett-Packard (NYSE:HPQ) are in the middle of similar journeys to break away from technology hardware. IBM used to be a dominating force in hardware, and HP is an industry leader in printers. But hardware is not the future of their businesses. Instead, software and services, particularly cloud-based, hold the highest growth potential.
Both companies are taking steps to bring their businesses into the new technological age, but they're also committed to returning cash to shareholders with dividends until their turnarounds materialize. With that in mind, let's see which stock might be a better pick for income investors.
Huge companies don't turn on a dime
IBM and HP are struggling to produce growth, and it's not hard to see why. Both companies continue to be dragged down by hardware. IBM's hardware group posted an 11% revenue decline in the last quarter. Fortunately, its other higher-performing businesses are picking up some of the slack. For example, security revenue jumped 20%, mobile revenue more than doubled, and cloud revenue was up more than 50% over the first half of the year. This allowed IBM to post just a 2% revenue decline last quarter.
HP remains dependent on printers, which is hurting the company. Total year-over-year revenue was up just 1% last quarter. Revenue for HP's printer segment (which provides 20% of the company's total revenue) was down 4% year over year in the quarter. Fortunately, HP is doing well in some other areas. The personal systems group increased revenue by 12% year over year, thanks to buoyant personal computer shipments and signs of a PC product refresh cycle.
HP and IBM still have much to offer dividend fans
The sluggish results for both IBM and HP on the top line are a concern. Clearly, they will need to re-engineer growth to ensure future cash flows remain strong. But you might be surprised to know that these twin technology giants still generate robust free cash flow. That's because, even though revenue growth is lackluster, they are huge and established companies with businesses that throw off lots of cash.
For example, HP generated $6.7 billion of free cash flow over the first nine months of its current fiscal year. By contrast, it has paid just $875 million of dividends to stockholders over the same period. That means its free cash flow payout ratio is a very modest 13%.
Over the first six months of its fiscal year, IBM racked up $3.6 billion of free cash flow and paid $2 billion worth of dividends to shareholders. That resulted in a free cash flow payout ratio of 57%, which is much higher than HP's ratio but still leaves more than enough room for further payout boosts.
Not surprisingly, HP and IBM have enough financial flexibility to provide their investors with regular dividend increases. Over the past five years, both companies have doubled their quarterly dividends. On a percentage basis, each has raised its dividend by 14% compounded annually, so they tie on recent average dividend increases.
HP's stock yields 1.7% at current prices, while IBM's yield is a larger 2.3%. This is because HP shares have rallied considerably over the past year, giving IBM an edge in yield.
It's hard to see a clear winner
In many ways, IBM and HP are very comparable dividend stocks. They offer similar yields, with identical dividend growth over the past five years. HP's free cash flow payout ratio is much better, which gives it a definite edge. At the same time, HP's future recovery prospects aren't as strong as IBM's.
Big Blue is making great progress in several new businesses in areas, such as the cloud, that are poised to fuel much better growth going forward. HP, though, has its hands tied: It still derives a large amount of its business from PCs and printers, which face a dubious future, and its new initiatives to break away from these older technologies are far less clear.
As a result, because of its slightly higher yield and better growth prospects, income investors would likely be better off picking IBM.
Bob Ciura has no position in any stocks mentioned. The Motley Fool owns shares of International Business Machines. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.