This year has been a bit of a roller coaster for IBM (NYSE:IBM) investors. The stock has fallen 13% since the beginning of the year, largely because of one disappointing quarter, announced in mid-October. The announcement was not only disappointing, but it brought forecasted weakness for the future as well. Notably, IBM finally bailed on its 2015 earnings per share target of $20. That earnings goal had been in place since 2010 and was a major marker in the road for the business.
While the short version looks like bad news, IBM has a lot going for it. That doesn't mean investors can take their eyes off the ball, though. Here are the two things dividend investors need to watch out for over the next few years.
IBM's transformation into a service business
Software as a service (SaaS) is the future of enterprise level technology. The days of buying a software package, having it installed, maintaining it, then upgrading it, and repeating the whole process are largely gone. Now, companies are paying for software that's hosted in the cloud, managed offsite, and gets upgraded along the way. Instead of paying one-time installation and repair fees, businesses now pay a recurring fee -- like a subscription.
IBM is moving into the SaaS model, which is a new world for it. The benefit is that SaaS providers can pull in higher margins, as the cost to run a SaaS business is lower because of its central nature, lack of onsite time, and lower demand for physical goods.
All of that is driven off the back of a meaningful cloud offering, which IBM has fallen behind on. The business is on track to generate $3.1 billion in annual revenue this year, but that's just a fraction of its overall revenue. Not only is it small internally, it's small compared to competition. Amazon's (NASDAQ:AMZN) cloud business is estimated to generate $5 billion this year, up 58% from $3.1 billion last year.
That means there's an uphill battle for IBM, but it also indicates the size of the prize. The cloud has moved from tech novelty directly into tech necessity, and IBM needs to hop on the train. Dividend investors need to know that the transition isn't going to happen overnight, nor is it going to be free.
Cash flow is going to fluctuate - alot
While the payoff is a higher gross margin, IBM is going to have to invest billions in the near future to expand its cloud offering. Most of that will be spent on the technology that underpins its cloud business, but there are costs associated with losing redundant staff, as well.
All of those costs aside, IBM has had some back-room moves change the way free cash flow appears on the balance sheet. Currently, the company is taking a hit from taxes related to the Lenovo transaction, which is pushing free cash flow down.
Through the third quarter, IBM has generated free cash flow of $8 billion; it had generated $8.4 billion over the same period by this time last year. It wouldn't be surprising to see that levelling off next year, either, as the billions spent on the cloud business are going to have a meaningful impact on the company's capital expenditures over the next few quarters.
The upside of all of this is simply that IBM is going through a transition phase and, even though cash is tighter, dividend investors are unlikely to be affected. The long play is IBM's bread and butter, and the investment going on right now is all part of that long play. Investors should expect revenue and earnings to take a hit as the business works through its transition phase, but ultimately, IBM will prevail.
Andrew Marder has no position in any stocks mentioned. The Motley Fool recommends Amazon.com. The Motley Fool owns shares of Amazon.com and 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.
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