IBM: Quantum Yield

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About: International Business Machines Corporation (IBM)
by: Stone Fox Capital
Summary

IBM led US in patents for the 26th consecutive year.

The dividend yield sits at the highest level in over a decade at 5.2%.

The stock continues to trade at only 8.5x forward EPS estimates.

The Red Hat deal provides a potential catalyst with a new CEO.

International Business Machines (IBM) continues to lead the country in technology development that doesn't actually lead to meaningful revenue growth. The technology company does generate enough to reward investors with a 5%+ dividend yield and a stock trading at only $120 with a potential big catalyst from the Red Hat merger. My investment thesis remains bullish on this dip to $120.

IBM Q logo Image Source: IBM website

Wrong Lead

IBM continues generating tons of patents (via Bloomberg Tech) without showing the financial results. The company has apparently been the top patent recipient for the last 26 years. The top patent list includes a mixed bag of big technology companies in the world including companies like Canon (CAJ) that have long struggled to generate growth similar to IBM.

Again, these data points question whether CEO Ginni Rometty is the right executive for the job. She has the company developing AI technology such as Watson and leading in areas like quantum computing and blockchain, yet the tech giant can't generate the revenue growth to bypass legacy declines.

A prime example is the discussion of quantum computing at CES 2019. The product sounds impressive, but the revenue potential doesn't exist until 2021. One has to question whether IBM is correctly utilizing the CES stage to drive growth or again just highlight more technology with no home.

Red Hat Impact

For this reason, the Red Hat deal is more important to shareholders than exciting new technologies that lead to possibly useless patents. The open-source cloud software company generates the revenue growth without overly touting new technology.

A big key to the merger is that the management team, including CEO Jim Whitehurst, plans to remain in charge of Red Hat while reporting to IBM CEO Ginni Rometty. Since he became the CEO of Red Hat back at the end of 2007, the stock has far outperformed the meager 8% gain of IBM.

Chart IBM data by YCharts

The investor community would likely cheer his replacement of Ginny as the CEO with her moving up to the Chairman role. One can only imagine what a strong tech leader could do with the technology that IBM develops based on those patents generated each and every year.

Following the merger agreement, Red Hat reported that recent Q3 revenues grew about 15% on a constant currency basis. The company is growing annual revenues by about $600 million so the additional revenue growth will help trim any revenue losses generated by IBM's legacy business. A big issue with the tech giant has been the constant revenue drops.

One Crazy Yield

The market likely sees more risk in the story due to the $34 billion cash deal for Red Hat. Hence, the dividend yield is now at a decade high over 5%. Considering the deal promises higher free cash flows from the current estimates of $12.0 billion in 2018, IBM should easily be able to continue covering the dividend payout of about $5.7 billion.

Chart IBM data by YCharts

Price Target Perspective

With the stock trading a tad below $120 and the average analyst price target up at $150, the analyst and investment community has a large disconnect with IBM. Most investors would associate a 30%+ total return that includes a 25% capital gain as a great investment opportunity, yet most analysts aren't even bullish on the stock.

Source: Yahoo! Finance

The other important perspective here is that the stock has generally traded above $150 since 2010. A price target below $150 actually indicates a very bearish view on a historical perspective despite the upside potential from the current price.

The more perplexing part of the story is that IBM has recently entered growth mode again. The company expects to earn $13.80 per share in 2018 with estimates now pushing the tech giant to nearly $14.50 in 2020.

Chart IBM EPS Estimates for Current Fiscal Year data by YCharts

The analyst community isn't forecasting significant EPS growth, but the company is expected to finally start growing the bottom line. About the only reason for the dividend yield to top 5% is if investors aren't convinced the company can continue paying the dividend long term.

A growing cash flow base resolves those fears.

Takeaway

The key investor takeaway is that IBM remains a quantum bargain trading at $120. The stock offers a 5.2% dividend yield while trading at $120. The stock only trades at 8.5x forward EPS estimates while the Red Hat deal offers some growth potential and more importantly the catalyst for a new CEO respected in the tech space.

Disclaimer: The information contained herein is for informational purposes only. Nothing in this article should be taken as a solicitation to purchase or sell securities. Before buying or selling any stock you should do your own research and reach your own conclusion or consult a financial advisor. Investing includes risks, including loss of principal.

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.