## Summary

- Free cash flow may grow by high single digit CAGR over the next few years driven by improved profitability and relatively steady capex trend.
- Continued share buybacks also will support dividend per share growth.
- A dividend per share CAGR of 11%-12% is sustainable over the next few years with both free cash flow and earnings dividend payout ratios being stable.
- Dividend yield on cost will rise to 3.0% based on my dividend forecasts.
- Current valuation only implies a 7.0%-7.5% dividend growth rate.

**International Business Machines** (NYSE:IBM) recently boosted its quarterly dividend by 16% to $1.10 per share. The dividend has grown by 15% CAGR since 2009. Given the solid historical growth rate, many investors wonder whether IBM can continue to sustain the pace. In this article, I will provide readers some perspective on IBM's future cash flow and dividend trends.

I have performed free cash flow projections to gauge IBM's capacity for dividend growth. My analysis started with consensus revenue estimates which predict sales to grow by just 1.4% CAGR from $97.4B in 2014 to $100.2B in 2016. The company's operating cash flow margin trended from 18% to 22% in the past five years. To be fair, I used the historical five-year average of 19% for 2014. I then assumed the cash margin to expand by 200 bps in the next two years and reach 21% in 2016. My assumption is based on a current consensus view that there will be about 300 bps EBITDA margin expansion from 2013 to 2016. For capital expenditures, I used the consensus estimate of $4.0B for 2014 and assumed spending to grow by 3% per annum through 2016. Based on the fair assumptions, IBM's free cash flow was projected to grow by 7.5% CAGR from $14.7B in 2014 to $17.0B in 2016 (see chart below).

Given that IBM is expected to pay out an annual dividend of $4.25 per share in fiscal 2014, I calculated total dividend spending in the year to be $4.4B based on my average share count estimate (discussed later). Hence, free cash flow dividend payout ratio in the year would be 30%, which is only slightly higher than 29% in 2013. To maintain a steady free cash flow payout ratio, IBM can grow its annual dividend payment by 7.5% per annum in 2015 and 2016 as this rate is in line with my forecasted free cash flow CAGR of 7.5%. In this case total dividend payment will rise to $5.1B by 2016 and the company would have about $10.3B-$11.9B excess free cash flow each year (see chart above).

Given IBM's commitment to returning capital to shareholders, I believe the company will continue to spend significant cash flow on share buybacks in the next few years. For 2014, I assumed the company to spend a total of $13.0B which is based on the reported Q1 repurchase of $8.2B and management's guidance of no more than $5.8B in the remaining three quarters. For 2015 and 2016, I assumed IBM to spend 90% of my forecasted excess free cash on this matter. Based on the average buyback price assumption of $190 for 2014 and an annual price growth rate of 10%, I estimated the average share count will drop to 948M by 2016. As a result, dividend per share was projected to grow by 12.2% CAGR from $4.25 in 2014 to $5.36 in 2016. Compared with consensus EPS estimates, my dividend forecasts imply the earnings dividend payout ratio will only rise modestly from 24% in 2014 to 25% in 2016 (see chart below).

As both free cash flow and earnings dividend payout ratios are projected to trend steadily, I believe my dividend per share forecasts are within a sustainable range over the next few years. However, as IBM's consensus long-term EPS growth estimate is lower at 10%, I expect the per share dividend growth rate will eventually decline to 10% over a medium to long run as the company simply cannot let the earnings dividend payout increase constantly.

The chart below shows a quarterly breakdown of my annual dividend per share forecasts. From 2014 to 2016, I expect the next dividend hike to be 11% in Q2 2015 and another one with a 12% increase in Q2 2016. Based on my projections, dividend yield on cost will gradually rise to 3.0% by Q2 2016, which is a record level for IBM.

Based on current annualized (forward basis) dividend of $4.40 per share and 10% cost of equity, the Gordon Growth Dividend Discount Model suggests that the current share price of $181 has only priced in a dividend growth rate of slightly below 7.5% (see chart below), which is notably below my 11%-12% estimate in the next few years. Hence, from a dividend perspective, income investors are recommended to accumulate IBM shares at the current level.

*All charts are created by the author, and historical data used in the article and the charts is sourced from S&P Capital IQ, unless otherwise specified.*

**Disclosure: **The author is long IBM. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.