Shares of IBM (IBM) have returned only 3.72% over the past 12 months. At $193.27 per share, the stock is trading at the mid-point of the 52-week trading range between $177.06 and $211.79 and offers a dividend yield at 1.8%. According to Capital IQ, sell-side analysts are generally not very bullish on the stock. Of the total 33 ratings, there are 8 buys, 5 outperforms, 19 holds, and 1 underperform. However, I am of the view that despite trading near the fair value, IBM remains a quality dividend investment given the robust dividend growth potential. In this article, I will elaborate the analysis that supports my view.
IBM appears to be trading within the fair value range based on the company's financial performance relative to its peer group (see table below), which consists of competitors in various fields such as Oracle Corporation (ORCL) and Cisco Systems (CSCO). Analysts in average predict IBM's revenue, EBITDA and EPS to grow at 2-year CAGRs of 1.0%, 4.3%, and 10.3% over the current and next fiscal years. The revenue and EBITDA growth estimates are significantly below the peer averages of 5.7% and 10.1%, respectively, and the EPS growth is only slightly higher than the average. In addition, IBM's EBITDA margin is forecasted to expand by 1.6% over the same period, compared to a higher peer-average estimate of 2.6%. On the profit side, IBM enjoys an above-average profitability. Except for the trailing gross margin, which is below the peer average, all of the company's other margin and capital return measures are higher than the par. It should be noted that IBM's ROE and ROIC ratios of 73.8% and 24.8% are more than twice of the peer averages. In terms of leverage and liquidity, IBM's trailing free cash flow margin is below the average. Due to strong profitability, the company has maintained a high interest coverage ratio. However, both IBM's current and quick ratios are below the par, reflecting a somewhat mediocre balance sheet.
To summarize the financial comparisons, the growth prospects appear to be IBM's primary weakness, but I believe the fair stock value should be somewhat in line with the peer average given the company's larger size, solid market share, and strong profitability. The current stock valuations at 9.2x trailing EV/EBITDA and 13.9x trailing P/E represent an average valuation premium of 8.6% over the peer-average trading multiples (see chart above), suggesting that IBM is reasonably valued.
Comparing IBM's valuation to that of the market, the stock's trailing EV/EBITDA multiple has outperformed the same valuation multiple of the S&P 500 index over the past 12 months, and it currently trades at a 10.8% premium (see chart below). I believe the premium valuation can be explained by IBM's higher estimated long-term earnings growth rate of 10.4% compared to the average estimate of 7.9% for the S&P 500 companies. It should also be noted that IBM's forward P/E multiple has underperformed that of the S&P 500 index over the past 12 months (see chart below), making me more comfortable with IBM's current valuation.
The stock currently offers a 1.8% dividend yield, which is safely backed by the company's solid free cash flow and commitment to continuously improve the dividend. The annual dividend per share had been raised by a significant 10-year CAGR of 18% from $0.55 in FY2001 to $2.90 in FY2011. The growth rate slowed down in the period between FY2007 and FY2008, but has stabilized at around 15% since then (see chart below). Additionally, the annual dividend payment historically represented only a small portion of the annual free cash flow, indicating that there is an ample slack for continued dividend hikes down the road (see chart below).
According to a 5-year dividend yield chart shown below, the yield stayed within the range between 1.6% and 1.8% most of the time since 2009. I believe the flat yield performance over the period is partially caused by a strong demand from income-oriented investors due to the current low-interest market environment, and I expect the flat yield performance to persist at least in the neat-term given that there is no sign that the developed market central banks will change their stance of monetary expansionary at any time soon. Therefore, assuming a target dividend yield between 1.6% and 1.8%, and supposing that the current annualized dividend per share of $3.4 would be raised by 10% (a low assumption given the average growth rate of around 15% over the past 3 fiscal years) to $3.7 in the May 2013 payment period, the conservative scenario would imply a stock value between $208 and $234, representing an average upside of 14.5%.
Bottom line, in the light of the fair valuation and the downside support from the expected strong dividend growth, I believe IBM should bear a solid margin of safety. As such, I recommend buying the shares now.
Comparable analysis table is created by author, all other charts are sourced from Capital IQ, all financial data is sourced from Morningstar and Capital IQ.
Disclosure: I am long IBM.