IBM: Sneaky Growth Play For Dividend Investors

| About: International Business (IBM)

Summary

IBM reported strong second quarter earnings but lower overall revenues that masked strong underlying trends in its cloud-related businesses.

IBM's Strategic Imperatives and bets in the Cloud Services are paying off, and now account for about 40% of the overall revenue.

With a high dividend yield, low valuation and a potentially strong position in the burgeoning cloud computing market, IBM deserves an allocation in a dividend-focused portfolio.

IBM (NYSE:IBM) surged past analyst earnings estimates, reporting an adjusted profit of $2.95/share, which was $0.06 better than the $2.89 consensus forecast. IBM's strong income performance came despite a 2% drop in its overall revenues, which continued a run of declining quarterly revenues dating back four years.

While its headline number was tepid, consistent with the last four years, this report was very different and marks a changing point in the IBM business. IBM reported a 12% rise in its Strategic Imperatives revenue, which now accounts for close to 40% of IBM's revenues in the trailing twelve months. Meanwhile, its Cloud revenues, which includes IBM's Cloud-as-a-service offerings - rose by 30%.

With IBM's Strategic Imperatives finally showing real traction, now is the time for Dividend Investors to consider the impact that growth will have on IBM's already hefty dividend. Initiating or bulking up their positions now, may be a great way for investors bet on growth and capture considerable dividend yield while they wait.

Dividend and Outlook. Investors are clearly not looking at IBM's headline revenue number when deciding to buy the stock. To wit, IBM's shares are up nearly 18% in the year-to-date, a performance that exceeds that of both the Dow Jones Industrial Average and the S&P500, both of which count IBM among its components.

Despite the strong performance of its shares, IBM's dividend yield remains robust at 3.46%, placing it among the top five of Dow components by dividend yield. A $10,000 investment in IBM will thus provide around $346 a year in passive income. IBM only recently raised its quarterly dividend to $1.40 per share. It has now increased its quarterly dividend by $0.10 or more each year - the last time it failed to do so was in 2009, when recession concerns warranted a more prudent capital return policy.

Dividend investors should likewise take note that IBM's average dividend yield in 2016 has been at its highest level over the last six years - from 2011 to 2015, its average dividend yield has ranged from 1.68% to 3.22%. The reason for this shouldn't be surprising: as we've mentioned, IBM's revenues have shown 17 consecutive quarters of annualized declines while IBM's average closing stock price of $143.5 in 2015 is 27% lower than its average closing stock price of $196.6 in 2012.

Considering IBM's high dividend yield and consistent dividend payment record, should investors consider buying IBM's stock? Perhaps.

While IBM has the capacity to continue paying dividends, as demonstrated by its passable financial strength ratios, it is highly-leveraged compared to other technology stocks. Indeed, IBM's leverage ratio of 6.9x bears more resemblance to a bank like JP Morgan (NYSE:JPM), which has a leverage ratio of 8.05x than its technology sector competitor, Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL), which has a nearly non-existent leverage ratio of only 0.24x. A lot of this has to do with the leveraged recapitalization that IBM engaged in over the past fifteen years, when its spent $110 Billion buying back stock while investing considerably less in R&D.

This is clearly something that IBM is mindful of - in its second quarter earnings release, it emphasized its R&D investments and strategic acquisitions over its capital return program. Indeed, IBM spent a total of $10 Billion combined on R&D, Capex and acquisitions in the first half of 2016 - or 2.5x what it returned to shareholders during the same period.

This bodes well for its forward prospects - something that IBM is keen to emphasize as it mentioned that its cloud services are growing at a 50% annualized rate while noting that its strategic imperatives now account for 38% of its revenue over the last 12 months. Considering these developments, it seems evident that IBM has decided to become a technology company again after years of chasing a high EPS target and serving as the poster child for capital returns. That said, analysts seem to be skeptical of its recent turn, judging from their 2.85% annual growth target for IBM over the next five years, a rate that is about a third of that for its competitors.

It remains to be seen whether those targets are underselling IBM's potential transformation (or refocusing, as the case may be) - but investors should note that cloud infrastructure services, where IBM is experiencing its fastest growth, is likewise the fastest-growing segment of public cloud services. To the extent that IBM is able to pivot in this direction and realize its cloud vision, it could become an under-the-radar growth play.

Despite this, IBM is still valued as a low-growth company, as evidenced by its trailing and forward price-earnings ratios, both of which are lower than that for the Dow and S&P500. IBM is also cheaper than the broader technology sector - and not just on a price-earnings basis but also in terms of its price-to-book, price-to-sales and price-to-free cash flow ratios. In short, even after considering its 18% climb in 2016, IBM is still cheap by most measures. For investors willing to take a long view of the stock, this could prove to be a golden opportunity.

Conclusion

Considering IBM's high dividend yield, consistent dividend payment record, low valuation and surprising performance in key technology growth areas, we believe that IBM warrants an allocation in a dividend-focused portfolio.

While there are certainly risks such as Brexit that could have second-magnitude effects in the form of negative currency translation, investors can mitigate this by accumulating the stock over time rather than buying it in one go.

Disclosure: I am/we are long IBM.

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.

Additional disclosure: Black Coral Research, Inc. is a team of writers who provide unique perspective to help inform dividend investors. This article was written by Jonathan Lara, one of our Senior Analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article. Company financial data is taken from the company’s latest SEC filings unless attributed elsewhere. Black Coral Research, Inc. is not a registered investment advisor or broker/dealer. Readers are advised that the material contained herein should be used solely for informational purposes. Investing involves risk, including the loss of principal. Readers are solely responsible for their own investment decisions.