Would You Believe IBM Has Deteriorating Earnings Quality And A Strong Dividend?

| About: International Business (IBM)

Valuentum loves to dig into the quality of earnings. We think the quality of earnings is just as important (if not more so) as the earnings themselves. If you haven't read about IBM's (NYSE:IBM) deteriorating earnings quality, we encourage you to read about it here. But it's difficult to argue about the quality of IBM's dividend growth prospects. Please take a gander at the dividend report below before we get started.

Image Source: Valuentum

IBM's dividend yield is solid, offering over a 2% annual payout at recent price levels. Though we prefer yields above 3% and don't include firms with yields below 2% in our dividend portfolio, for a company that is so resilient as IBM is, we're keeping a close eye on the firm.

We think the safety of IBM's dividend is EXCELLENT. As many know, earnings can fluctuate in any given year, so using the payout ratio in any given year has some limitations. Plus, companies can often encounter unforeseen charges, which make earnings an even less-than-predictable measure of the safety of the dividend in any given year. We know that companies won't cut the dividend just because earnings have declined or they had a restructuring charge that put them in the red for the quarter (year). Management teams are focused on the long-term relationship between earnings/cash flow growth and dividend payments. As such, we think that assessing the cash flows of a business allows us to determine whether it has the capacity to continue paying these cash outlays well into the future. We do this quite a bit, too, in assessing earnings quality.

That has led us to develop a forward-looking measure called the Valuentum Dividend Cushion™. The measure is a ratio that sums the excess cash a company has on hand (cash and cash equivalents less total debt) plus its expected future free cash flows (cash flow from operations less capital expenditures) over the next five years and divides that sum by future expected dividends over the same time period. Basically, if the score is above 1, the company has the capacity to pay out its expected future dividends. As income investors, however, we'd like to see a score much larger than 1 for a couple reasons: 1) the higher the ratio, the more "cushion" the company has against unexpected earnings shortfalls, and 2) the higher the ratio, the greater capacity a dividend-payer has in boosting the dividend in the future. For IBM, this score is 3.3, offering both a nice "cushion" and revealing excess capacity for future dividend growth (above and beyond our existing dividend growth projections--please view bottom right table in the image above).

Now on to the potential growth of IBM's dividend. As we mentioned above, we think the larger the "cushion" the larger capacity it has to raise the dividend. However, such dividend growth analysis is not complete until after considering management's willingness to increase the dividend. As such, we evaluate the company's historical dividend track record. If there have been no dividend cuts in 10 years, the company has a nice growth rate, and a nice dividend cushion, its future potential dividend growth would be EXCELLENT, which is the case for IBM. The firm is quite willing and able to raise its dividend.

However, we don't just stop there -- we make it easy for the individual investor to view the health of a dividend with a simple view of a matrix. One can see in the image above that IBM has a very solid dividend--the cross section of its EXCELLENT safety and EXCELLENT future potential growth scores (view matrix). We have these matrices for hundreds of stocks on our website. Though our valuation process is documented elsewhere (in the 16-page report on our site), we include our assessment of the risk associated with the potential for capital loss in the image above (offering dividend growth investors a robust and straightforward picture). In IBM's case, we think the shares are fairly valued, so the risk of capital loss is MEDIUM. If we thought IBM was undervalued, we'd consider the risk to be LOW.

All things considered, we think IBM's dividend has significant room for further expansion as it works to deliver on its elevated earnings goals. Still, we'd take note of IBM's deteriorating earnings quality, which is not something management should be proud of (and it isn't).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.