IBM: Darkest Before Dawn?

| About: International Business (IBM)


After the recent run up in price, IBM needed the mother of all earnings report to stay up.

It's still a good stock to own, but for the right reasons.

Upcoming dividend increase will push the yield beyond 4%.

IBM (NYSE:IBM) reported its Q1 results and while the headline numbers seemed alright, the stock took a beating and rightly so. The stock had run more than 25% in about two months, something that is very rare for old-age tech stocks like IBM.

Suddenly, articles and news items on Seeking Alpha are filled with comments like "Big blue is now small blue" and "Big blue is shrinking blue." It's easy to see that revenue is declining but EPS is holding up due to buybacks and cost cutting. Since IBM pays a hefty dividend, the buybacks have a double positive effect where the company can not only increase its EPS but also reduce the long-term dividend commitment to shareholders.

Speaking of dividends, IBM has been more than handily compensating investors for its slowing organic growth by giving out huge dividend increases. The table below shows the dividend increases for the last five years, with the average dividend growth rate [DGR] being almost 15%.

Source: Yahoo Finance

The company guided 2016 EPS to come in at $13.50, which gives the stock a trailing payout ratio of less than 40%. Assuming IBM sticks with the five year average DGR of 15%, investors can expect a new annual dividend of nearly $6 per share when the company announces its dividend increase this month. That will give investors a 4% yield for buying right here, right now.

Even this humongous dividend increase will keep the forward payout ratio to less than 45%. Think about it. For all the negative headlines and sentiments, one would think IBM is actually losing money and doesn't have enough cash or cash flow to pay its dividends.

Speaking of cash flow, let's evaluate the company's cash flow strength. Since EPS can be misleading, we prefer using free cash flow numbers to see how far the dividends are covered.

  • Total shares outstanding: 960 million. This number is down 20% from 1.2 billion in 2011/2012.
  • Using our projected new quarterly dividends of $1.50 per share, the company needs $1.40 billion to meet its dividend commitments.
  • IBM's lowest quarterly free cash flow in the last five years was $2.20 billion.
  • Again, let's step back and think about it. The lowest free cash flow in recent times is 80% higher than the company's dividend commitment to shareholders.
  • IBM also guided 2016 free cash flow to be between $11 billion and $12 billion.
  • In short, dividends are extremely safe and there is plenty of room for future increases.

Speaking of future, the table below shows the five year returns for investor buying IBM here from the income perspective. If you believe 15% increases are not going to be the norm, let's just assume 7% increases annually. That would still give investors a yield on cost of close to 5.50% in five years. Keep in mind, a growing yield level is much safer than one which starts out high but is shaky.

And it's not like the business is going bankrupt or is closing down. Investors need to realize the fact that this is not a growth stock and has rarely been one in the recent years. This is not IBM's first challenging situation and most certainly it won't be the last. A company that has continuously reinvented itself deserves some respect for its history.

IBM is not a bad stock to own. Far from it. But own it for the right reasons. Buy it when expectations are low and depressing.

Disclosure: I/we 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.