IBM: Still Worth Buying

| About: International Business (IBM)

Summary

IBM has a long history of producing good returns and dividends.

It is still struggling.

At this price, IBM is worth the risk.

International Business Machines Corporation (NYSE:IBM) is a computer company with a long history. Not only has it frequently been at the forefront of innovations like the IBM PC, but also it has often been written off as dead when the computing world changed. So far, IBM has been able to bring itself back to a leadership position by reinventing itself. Currently, it is in the middle of yet another reinvention stage. Is it succeeding, and what do its current efforts mean for Dividend Growth investors who might be interested in its very attractive dividend?

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Why Invest in IBM?

What do DG investors get from investing in IBM? Some investors will look at the dividend of $5.60, which works out to a current yield around 3.45%, and want IBM for that alone. But unless the dividend can be sustained, and unless earnings grow to support growing the dividend over time, a large dividend doesn't make a stock a good DGI stock.

Using this website to estimate past returns, one can see that IBM purchased on January 20th, 1998 (when DIA first became publicly available), would have produced a total return CAGR of 7.62%. DIA, which tracks the DOW, would have produced 7.11%. SPY would have produced 6.30%.

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These two charts illustrate what else a company needs to do to be a good DG stock. In the first chart, one can see that IBM's dividend regularly grows with no declines, something that dividends from the indexes do not do (even if you just look at the trend lines and ignore the monthly swings). In the second chart, one can see that earnings exceed the dividend and have until recently been growing faster than the dividend payment. This shows that despite recent declines in earnings, IBM still has plenty of room to grow the dividend.

Looking at the full Morningstar analyst report, it rates IBM with three stars for fairly valued, and gives a fair value price of $145. One positive sign it points to is that IBM is ahead of schedule in switching its revenues to its new initiatives, now getting 40% of revenue from them when it targeted reaching that level in 2018.

Robert X. Cringely makes a very good bull case argument in this article. I recommend reading all of his articles on IBM before buying any more. It's best to know the worst before you buy, but I think Robert is too pessimistic. He is correct in that IBM's new products have yet to turn around the company; declining revenue and earnings show that, but he discounts too much the momentum that IBM's current products have and the weight they will have in driving sales of the newer products and services. I think it will take longer than management would like, but I still think it can turn the company around.

From my own perspective, I see that IBM still has a pretty big job to do. The company has to slow sales declines in its legacy products so that it has the cash to build its new products and services. It seems to me that the new products and services have not been as successful as they need to be.

Transaction Processing Software has been moved inside of Cognitive Solutions, in part because the legacy software performs similar tasks as Cognitive Solutions. Hopefully, this means that IBM will be using Watson and other new technologies from the Cognitive Solutions group to reengineer features currently part of TPS. This will help by making TPS better and leverage customers already using TPS into new products from CS. So far, Watson hasn't lived up to its promise, but hopefully this reorganization means that IBM's management is looking for ways to push it to live up to that potential.

One area that concerns me is customer complaints about the new product offerings. Customers feel the new products aren't as integrated as the competition's products. They also complain that there are too many choices, and the choices are too complex and confusing. From my own experience developing software, it can be very hard to balance offering enough choices and features to make a product useful to a wide range of customers and to make sure that those choices and features don't confuse users and make your product hard to use. It can take a lot of effort to organize the user interface so that users who need a feature can find it, and users who don't need a feature don't have it confusing them. IBM seems not to have hit upon the correct balance. Also from experience, once you get that balance wrong, it can be expensive to get the balance right and then even more expensive and time consuming to convince customers that the issue has been resolved.

From my own experience developing software, when you want users to embrace a new technology, there are several things you need to do. First, the users you want to switch have tasks they need to do, and many of those tasks are handled by their existing software. If you want to get them to switch to something new, your new tool has to perform all the tasks of the tool that will be replaced. The second thing you need to do is to give them a reason to switch. The easiest thing to do with a new tool is to add features that will enable them to do even more tasks. I think the way forward with Watson and the other new technology in the Cognitive Solutions group is to use that technology to perform some and eventually all of the tasks that TSP now performs. And then add additional tasks that TSP doesn't do, or add in more data sources.

Looking at all the numbers, IBM has been a very good company to invest in the past. Recently, it has struggled, and I don't see that it has turned the corner yet. However, it is making moves to resolve its problems and has begun the process of turnaround. It looks to me like it will be able to do so, but in order to invest, I will want a discount to fair value to help mitigate the risk that it will be unable to turn the company around.

What is a Good Price?

So far, I think IBM still has a lot of life left in it. But I think there is a reasonable risk that it isn't done shrinking yet, so in order to buy shares, I am going to want to buy at a substantial discount.

Plugging in the standard numbers for DDM, where I put in the dividend, the lowest dividend increase rate of the set of latest increase, one-year DGR, three-year DGR, five-year DGR and 10-year DGR, 3% into the terminal dividend increase rate and 6.4% into the discount rate (also called expected return rate), here is what comes out:

I always like to compare what I get from DDM with a source that uses some other method of determining fair value. Morningstar uses a different method and is pretty good for most companies. I also get its analyst reports free from my broker. When Morningstar produces a fair value number that is significantly different (more than about 20%) from what I get with DDM, I look at what assumptions I used to produce the numbers I put into the calculator.

Sometimes, for instance, due to a small dividend payment at the start, the rate of increase for the past just can't be maintained. I covered a case like that in my article on UNH, where it had frozen its dividend for a couple of years, and then the business took off, so it was able to make big increases in a pretty small dividend. But at the same time, it just wasn't realistic to assume it could continue that rate of increase for much longer.

IBM, I think, is a different case. Here, the dividend has been increased, but that rate is slowing down, in part because revenues and earnings are slowing or shrinking. Given the declining revenue, the struggle to grow EPS and the uncertainty of the new initiatives, I think it's more realistic and certainly more prudent to project that the dividend will grow at about the same rate as earnings. Using this rate will ensure that one doesn't pay too much given the level of risk.

Looking at the CCC list, I see that the projection for next five years' growth (per year) is 2.9%. So replacing the last dividend increase of 7.69% with 2.9% gives a value of $166.88.

Using Morningstar's number and my DDM number, I get a price range of $145 to $168 for fair value. Given the current market price of $164, IBM falls towards the top of the range.

Can Options Help?

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Looking at the January 20th expiration date, I see that the $160 put pays about $2.75 in premium. For 53 days holding that is far more than even the generous IBM dividend. The $165 call also looks pretty good to use for a buy-write transaction (where you buy the stock, then write a covered call). The premium of around $4 will move the current share price down quite a bit. And given the high price of the stock and thus the large amount of cash needed to buy 100 shares, a buy-write when you already hold shares of IBM might be even more attractive as all you would need to buy is enough shares to get to the next multiple of 100 shares.

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Looking at the details for the $160 put, the numbers look promising. Using a limit order, it shouldn't be too difficult to clear more than $270 for a contract. And that will give you around a one-in-three chance of getting the shares at a pretty good price once the contract expires on January 20th.

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Looking at the details for the call, it too looks promising. The delta of 0.52 says that there is about a 52% chance of your shares being called away, which is a bit high, but not outrageously high. The $170 call also pays a reasonable premium and lowers the chance of losing your shares to about one in three.

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Conclusion

IBM is clearly still a company in transition. The company is neither clearly doomed nor back on top. Going forward, I would look to see how much functionality IBM offers from the legacy TPS in new products from the Cognitive Solutions group. The security software seems to be a hit with big companies; going forward, I would want to see better penetration into smaller companies.

IBM has faced bigger challenges in the past and still come out a stronger company. It still looks to me like that will be the case from the current difficulties. I think the current price represents an opportunity to add a good company to your portfolio even if it is with some risk. A couple of dollars cheaper on the price would be an even better opportunity as it would help lower the risk.

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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in IBM over 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.