IBM: Income Play With Very Poor Total Return

Summary

• IBM has increased its dividend for 10 of the last 10 years, with a present yield of 3.9% well above average.
• Its return underperformed the Dow average for my 54-month test period by 69.92%.
• IBM was once a great company but has been slow to keep up with the changes in computer software and application technology.

This article is about International Business Machines (NYSE:IBM) and why it's a buy for the income investor who thinks it will grow in the next year. This is a technology company. I have had comments in previous articles about why I compare performance to the Dow average. I use the Dow average for performance comparison because six of the companies in the Good Business Portfolio are in the Dow, and they got there by being good businesses that make money in good and bad times. So, I will look at some other Dow companies and see if they perform well enough to add to my portfolio. The seventh name is IBM, and it's an avoid for the total return investor. This study has come up with one great company, 3M (MMM), and another which has fair potential, Intel (INTC). The others were poor investments for me, using my Good Business Portfolio Guidelines.

Fundamentals of IBM will be reviewed in the following topics below: The Good Business Portfolio Guidelines, Total Return and Yearly Dividend, Last Quarter's Earnings, Company Business and Takeaways And Recent Portfolio Changes.

I use a set of guidelines that I codified over the last few years to review the companies in The Good Business Portfolio (my portfolio) and other companies that I am taking a look at. For a complete set of the guidelines, please see my article "The Good Business Portfolio: Update To Guidelines and July 2016 Performance Review". These guidelines provide me with a balanced portfolio of income, defensive, total return and growing companies that hopefully keeps me ahead of the Dow average.

Good Business Portfolio Guidelines

IBM passes 8 of 11 Good Business Portfolio Guidelines, a poor score (a good score is 10 or 11). These guidelines are only used to filter companies to be considered in the portfolio. Some of the points brought out by the guidelines are shown below.

The company meets my dividend guideline of having dividends increase for 10 of the last 10 years and has a steady increasing dividend for years with a yield of 3.9%, and is therefore a choice for the dividend income investor. The average 5-year earnings payout ratio is good at 28%. After paying the dividend, this leaves cash remaining for investment in expanding the business and increasing the dividend.

This is a large-cap company with a capitalization of $150 billion. The size of IBM plus its cash flow of $16 billion give it the ability to increase the business going forward, increase dividends and buy back shares.

I also require the CAGR going forward to be able to cover my yearly expenses. My dividends provide 3.2% of the portfolio as income, and I need 1.9% more for a yearly distribution of 5.1%. The three-year forward CAGR (S&P Capital IQ) of 3.0% is well below my requirement with almost no growth.

Looking back five years, $10,000 invested five years ago would be worth over $9,200 today. This makes IBM stock a poor investment for the total return investor looking back, but has future growth potential as the Information Technology sector continues to grow.

The company's S&P Capital IQ rating is three stars or Hold, with a target price of $175. IBM stock price is presently 14% below the target. It is under the target price at present and has a low P/E of 11, making IBM a fair buy at this entry point if you can take the slow growth.

One of my guidelines is, "Would you buy the whole company if you could?" The answer is "No" - the company's dividend stream has a good yield, but the growth is almost negative in a growing industry. The Good Business Portfolio likes to embrace all kinds of investment styles but concentrates on buying businesses that can be understood, makes a fair profit, invests profits back into the business and also generates a fair income stream. Most of all, what makes IBM interesting is the growing business the company is in, with cloud computing growing by leaps and bounds. Can it get its act together and start to grow with the new technology.

Total Return And Yearly Dividend

The Good Business Portfolio Guidelines are just a screen to start with and not absolute rules. When I look at a company, the total return is a key parameter to see if it fits the objective of the Good Business Portfolio. IBM's total return strongly underperforms the Dow baseline in my 54-month test compared to the Dow average. I chose the 54-month test period (starting January 1, 2013 and ending to date) because it includes the great year of 2013 and other years that had fair and bad performance. The poor total return of -6.52% makes the stock a poor investment for the total return investor looking back, but it does have an above-average yield for the income investor. IBM presently has a yield of 3.9%, which is above average for the income investor but is mitigated by the poor growth and total return.

Dow's 54-month total return baseline is 63.42%.

Company Name	54-month total return	Difference from Dow baseline	Yearly dividend percentage
International Business Machines	-6.52%	-69.92%	3.9%

Click to enlarge

When I scanned the 5-year chart, IBM has a poor chart that generally just goes down year after year. Compare IBM's chart to that of Johnson & Johnson (JNJ) that goes up to the right and grows slowly. Which one would you invest in?

IBM data by YCharts

Last Quarter's Earnings

For the last quarter on April 18, 2017, IBM reported earnings of $2.38 that beat expectations by $0.03 and was higher compared to last year's figure of $2.36. Total revenue came in at $18.16 billion, missing expectations by $230 million and lower 2.8% year over year. This was a fair report, with the bottom line increasing, top line decreasing and with earnings higher than last year's. The next earnings report will be out in July 2017 and is expected to be at $2.75, lower from last year's $2.95.

(Source: Earnings Call slides)

Business Overview

IBM is the largest provider of IT services in the United States and in foreign countries.

International Business Machines is a technology company. The Company operates through five segments: Cognitive Solutions, Global Business Services (GBS), Technology Services & Cloud Platforms, Systems and Global Financing. The Cognitive Solutions segment delivers a spectrum of capabilities, from descriptive, predictive and prescriptive analytics to cognitive systems. Cognitive Solutions includes Watson, a cognitive computing platform that has the ability to interact in natural language, process big data, and learn from interactions with people and computers. The GBS segment provides clients with consulting, application management services and global process services. The Technology Services & Cloud Platforms segment provides information technology infrastructure services. The Systems segment provides clients with infrastructure technologies. The Global Financing segment includes client financing, commercial financing, and remanufacturing and remarketing.

(Source: Reuters)

Overall, it is a fair business with low CAGR projected growth, and the share price has slowly been going down over a long period of time. I think it is best to wait and see if the new cloud business provides IBM with the growth needed to make this a good investment.

(Source: Earnings Call slides)

The economy is showing moderate economic (about 1.7%) growth right now and the Fed has raised rates in June 2017 with future rate increases dependent on the United States economy. The Fed projects for 1 more increase in 2017. I feel the Fed is going slow - it doesn't want to trigger a slowdown in the economy.

In the first quarter, we delivered over $18 billion of revenue, operating pretax income of $2.1 billion and operating earnings per share of $2.38, which is up year to year. This is in line with the view we provided back in January and keeps us on track to our full year expectations for earnings per share and free cash flow.

In the first quarter, we continued to deliver strong performance in our strategic imperative with revenue up 13% at constant currency. As is typical, I'll focus on constant currency growth rates throughout. Our Cloud offerings were up 35% this quarter; led by cloud as a service, which was up over 60%; Analytic, the largest of our strategic areas, was up 7%; Mobile was up over 20%; and Security up 10%. We also continued to deliver core capabilities to our clients running mission critical systems and processes. Many of these products provide the foundation of hybrid environments, enabling our clients to get more value from there on premise data and applications. Some of these key franchises are growing like WebSphere, while others are declining as they are in declining markets. But all are high value.

...

As part of the transformation, we've made significant investments and shifted resources. This level of investment and a longer return profile of the cloud of the service businesses are reflected in our margins. Our foundation is now solidly in place. And while the investments will continue, our focus shifts to improving the returns on these investments by building scale and realizing operating efficiencies, keeping us on track to our full year objectives. And so our first quarter results once again reflect the success we’re having in our strategic imperatives. We grew 13% in the quarter, which was compared to our strongest growth quarter last year. Over the last 12 months, our strategic imperatives together generated nearly $34 billion in revenue and now represent 42% of our total revenue.

(Source: Martin Schroeter, Senior Vice President and Chief Financial Officer, April 27, 2017, Earnings Call transcript)

This shows the feelings of the top management regarding continued growth of IBM and about delivering good value to the company's customers and shareholders.

Takeaways and Recent Portfolio Changes

The stock is an investment choice for the income investor with its above-average yield and low P/E, but this is mitigated by the slow growth and poor total return. The Good Business Portfolio will not consider IBM as an investment for the portfolio because of its slow growth. I keep the portfolio at 25 companies or less, since I can't keep track of more than that and 25 provides good diversification. There isn't an open slot in the portfolio at this time.

I wrote some HOG July 21 strike 54.0 calls on a portion of the holding. If the calls remain in the money, they will be moved up and out as it gets closer to the expiration date. These calls can make 4% in a little over two weeks, if the price remains the same.

Recently, on June 19, I trimmed Boeing (BA) from 10.1% of the portfolio to 9.6%. It's a great company, but you have to be diversified. The Paris Air Show was great for Boeing, and the company easily beat Airbus (OTCPK:EADSF) in orders by a mile. Boeing is ready for another trim.

I added to the position of Digital Realty Trust (DLR), now at 2.6% of the portfolio. I feel the computer industry facilities business has nowhere to go but up, and DLR pays an above-average 3% dividend. I wrote an article on Digital Realty Trust this year, if you are interested. This is another specialty REIT in a growing sector.

I trimmed Harley Davidson (HOG) to 1.3% of the portfolio. Growth looks likely to be negative again this year. S&P raised HOG target to $60, but sales look slow for a while. MMM is intended to be bought after the HOG position has been sold off.

I started a position (position number 25, portfolio now full) in American Tower (AMT), a specialty REIT, at 0.4% of the portfolio. The company's earnings for the first quarter were great, beating expected by $0.13, with revenue increasing 21.3% year over year.

I added to the position of Texas Instruments, now at 4.4% of the portfolio - a full position. S&P raised the target price of Texas Instruments (TXN) to $84 from $77.

I increased the position of Omega Healthcare Investors (OHI) to 6.2% of the portfolio. I wanted a little more income.

The Good Business Portfolio generally trims a position when it gets above 8% of the portfolio. The four top positions in The Good Business Portfolio are, JNJ at 8.4% of the portfolio, Altria Group (MO) at 8.0% of the portfolio, Home Depot (HD) at 8.3% of portfolio and Boeing at 10.1% of the portfolio. Therefore, BA, JNJ, MO and HD are now in trim positions.

Boeing is going to be pressed to 10% of the portfolio because of it being cash flow-positive on 787 deferred plane costs at $316 million in the first quarter, an increase from the fourth quarter. The first-quarter earnings were good, with Boeing beating estimates by $0.07 at $2.01. S&P Capital IQ also raised its one-year target for the company to $210. If Boeing is still above 10% of the portfolio after the next earnings report on July 25, it will definitely be trimmed to under 10%.

JNJ will be pressed to 9% of the portfolio because it's so defensive in this post-Brexit world. The company's earnings in the last quarter beat on the top and bottom lines, but Mr. Market did not like the growth going forward. JNJ is not a trading stock but a Hold forever. It is now a Strong Buy, as the healthcare sector remains under pressure.

For the total Good Business Portfolio, please see my article titled "The Good Business Portfolio: 2017 1st Quarter Earnings and Performance Review" for the complete portfolio list and performance. Become a real-time follower, and you will get each quarter's performance after the earnings season is over.

I have written individual articles on JNJ, Eaton Vance Enhanced Equity Income Fund II (EOS), General Electric (GE), Ingersoll-Rand (IR), MO, BA, PepsiCo (PEP), OHI, TXN, DLR and HD that are in The Good Business Portfolio, and other companies being evaluated by the portfolio. If you have an interest in these, please look for them in my list of previous articles.

Of course, this is not a recommendation to buy or sell, and you should always do your own research and talk to your financial advisor before any purchase or sale. This is how I manage my IRA retirement account, and the opinions on the companies are my own.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

Analyst’s Disclosure: I am/we are long BA, JNJ, HD, OHI, MO, HOG, IR, TXN, DLR, PEP, INTC. 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.