IBM Cloud Will Drive Cash Flows And Dividends

Arturo Neto, CFA profile picture
Arturo Neto, CFA
11.02K Followers

Summary

  • The acquisition of Red Hat will eventually drive revenue growth - the one key metric that Wall Street is focused on.
  • Share repurchases might slow due to the company's focus on debt reduction, but dividend growth should continue.
  • After the recent selloff, the stock price looks like a bargain relative to its historical trading range and relative to peers.
  • Looking for a portfolio of ideas like this one? Members of The Income Strategist get exclusive access to our model portfolio. Get started today »

In our previous article, we talked about how IBM (NYSE:IBM) has realigned its strategy around cloud computing to cope with declining year-over-year revenue growth. IBM’s hopes of competing with other tech giants in an effective way rests upon its "Cloud and cognitive software" segment, which offers cloud-based infrastructure and AI-embedded platform services. The company’s cloud strategy is playing a pivotal role in improving bottom line performance amid sequential revenue declines. In Q3 2019, IBM beat analyst earnings estimates with operating earnings of $2.68 per share. However, it missed analysts’ revenue estimates with a y-o-y revenue decline of 3.9%. Further, the company’s Global Technology Services and Systems segments reported a revenue decline of 4% and 14%, respectively. As usual, IBM’s revenue dip has triggered a post-earnings sell-off as investors remain concerned about its revenue trajectory and less impressed by its earnings growth.

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Source: IBM Q3 2019 earnings presentation

On the dividend front, IBM continues to maintain a steady dividend yield, however, primarily due to robust cash flow, even though the price decline makes the dividend yield look even more attractive. By relying on its cloud strategy, IBM continues to generate free cash flow of approximately $12 billion with a normalized free cash flow realization rate of more than 100%. In Q3 2019, IBM used the cash flow to return cash to shareholders by paying $4.3 billion in dividends and making $1.4 billion of share repurchases.

Currently, IBM’s financial results are being perceived as a mixed bag by income-seeking investors who are seesawing between pessimistic and optimistic outlooks that analysts are projecting. Hence, it's critical to analyze how IBM plans to win investor confidence by boosting revenues and sustaining its dividend. At this juncture, IBM has its hopes pinned on new offerings like the Red Hat OpenShift platform and the Z15 mainframe that will help drive the company’s performance and help clients with their digital transformations. These solutions have the potential to deliver a winning value proposition to enterprises who are rapidly adapting to the "hybrid Multicloud" environment.

Growing with Red Hat

With regard to its cloud strategy, IBM wants to dominate the hybrid cloud market which is projected to grow from $44.60 billion to $97.64 billion in 2023 at a CAGR of 17%. To differentiate itself from the competition, IBM has acquired Red Hat for helping enterprises securely deploy, run, and manage mission-critical workloads across multiple cloud-hosting environments.

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Source: IBM 2019 Investor Briefing

During Q3 2019, IBM closed the $34 billion Red Hat acquisition and absorbed the subsidiary into its "Cloud and Cognitive software" business segment. The acquisition already has begun to bear fruit as the subsidiary generated $371 million in revenue, exceeding the company’s estimate by $21 million. Further, Red Hat has played a key role in boosting IBM’s Q3 2019 revenue by 6.4% in comparison to the previous year. In Q3, Red Hat’s revenue increased by 20% in comparison to the 14.8% revenue growth that the subsidiary achieved as a separate company. And while overall revenue has been disappointing, IBM’s efforts to capture the hybrid cloud opportunity appear to be going in the right direction as its cloud revenue within the "Cloud and Cognitive software" segment has increased by 63% in Q3 2019 (albeit from a low base).

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Source: IBM Q3 2019 earnings presentation

Much of the demand for Red Hat products is driven by the OpenShift platform which enables cloud applications to be deployed on private as well as all leading public clouds like AWS, Microsoft Azure, IBM Cloud, Google Cloud Platform and Alibaba. The OpenShift platform is extremely popular among developers who wish to automate and simplify the process of application development for a hybrid cloud infrastructure.

Clients are particularly unlocking the value of the platform by integrating it with other value-add products and emerging technologies. For example, developers are using OpenShift with Ansible, an application deployment tool, to automate cloud application deployment. IBM also is capitalizing on OpenShift by combining it with other popular offerings like IBM Cloud Pak, an AI-based solution that can connect to applications and data across multiple clouds.

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Source: IBM 2019 Investor Briefing

Products like OpenShift and Cloud Pak are helping IBM win customer confidence and these solutions have helped the company win more than 1,800 clients in a short span of time.

In response to the strong demand for the platform, IBM also has begun to offer technology consulting services for Red Hat solutions to leverage its expertise in digital reinventions and the management of mission-critical workload. It's also accelerating Red Hat adoption by marketing the product to its higher-tier customers.

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Source: IBM 2019 Investor Briefing

In Q3 2019, IBM helped Red Hat expand its footprint at Visa which has begun to deploy open source solutions to accelerate the adoption of its innovative development platform amongst its clients. In another development, Spanish retailer El Corte Ingles opted to seek IBM’s implementation services and Red Hat’s OpenShift platform to implement its hybrid cloud strategy as well.

Advantage Mainframe

An additional spurt in IBM’s revenue might be driven by its mainframe business because mainframes are poised to play an important role in the evolving hybrid Multicloud environment. Mainframe servers are known to provide massive processing power, high reliability and the flexibility to manage diverse workloads. Further, enterprise demand for mainframes will be driven by an ever increasing need to securely connect to data sources and move workloads between multiple sites as well as distributing data across geographical borders to enhance efficiency and collaboration.

For years, IBM has been a dominant player in the global mainframe market and its "Z" server system has been adopted by a significant number of end users. The Z mainframe platform has proved to be an enduring legacy platform that has boosted revenue from time to time because of its popularity among major banks, insurers, government agencies and healthcare organizations. The Z systems also are in demand from industries that are still relying on mainframes to cut data center space and increase energy efficiency.

One way the mainframe business has sporadically helped revenue is by launching a new mainframe within the "Z" product line every few years. Historically, the new upgrades have caused a 4-5 quarter surge in mainframe sales for the company. The Z14 server was the latest flagship mainframe product that was particularly instrumental in breaking a long streak of revenue declines. The huge success of the Z14 mainframe was mainly fueled by major banks and financial institutions that relied on the platform for its security capabilities.

However, the Z14 has reached the declining phase of its product cycle and it's no longer the cash cow that drives revenue growth. During Q3 2019, IBM’s Z revenue decreased by 20% and the decrease has impacted hardware revenues also, which fell by 16%. In an attempt to revive sales, IBM has offered a fresh twist on its Z14 product line by launching the new Z15 mainframe system.

The Z15 not only surpasses its predecessor in performance but also in data privacy capabilities, which is its key selling point – a key feature with the increasing importance of cybersecurity and privacy. The new mainframe is built upon the security features of the Z14 while adding a key feature called "Data Privacy Passports" which ensures that data privacy is automatically maintained across hybrid Mutlicloud environments.

IBM’s mainframe business also will benefit from the Red Hat acquisition as the Z15 mainframe and its z/OS operating system can be bundled with the OpenShift platform. A combination of the Z15 mainframe and Red Hat is more likely to gain adoption as it provides customers a single window to control applications and data irrespective of its location. Additionally, a broader range of developers that use OpenShift will be able to create applications for the Z15 mainframe without any special training.

Positive Tailwinds

At the moment, IBM enjoys several tailwinds which ensure that its new Z15 mainframe triggers another successful upgrade cycle. The growing focus on cybersecurity and data privacy by enterprises bodes well for IBM as its Z15 mainframe will be integrating cybersecurity capabilities within each customers’ cloud strategy.

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Source: Juniper Research

More specifically, the company will benefit from increased cybersecurity spending by two of its key customer segments, namely financial institutions and government bodies. These two segments will be playing a key role in driving global cybersecurity market growth from $124 billion in 2019 and $170.4 billion in 2022.

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Source: IDC

Banks and financial institutions also are facing increasing pressure from regulators to provide high-quality data for complying with regulatory mandates and industry-specific regulations. As a result, financial institutions are spending an average of 10% of their IT budget on cybersecurity. Like financial institutions, the federal government also is boosting IT spending to boost cybersecurity at every possible level. In 2019, the president’s budget allocated $15 billion for cybersecurity spending which has increased 4.1% in comparison to 2018.

The evolution of cybersecurity as a key business priority also will boost demand for IBM’s threat management software and products like QRadar and X-Force. Within the security domain, IBM already has established itself as a leading enterprise security vendor whose security products have delivered strong performance to date. These profitable security solutions are still resonating well with clients like the LA Cyber Lab, a non-profit organization, which is collaborating with IBM along with the City of Los Angeles to provide threat intelligence solutions to local businesses to fight cybercrime.

Future Revenues

In Q4 2019, the company expects to maintain robust free cash flow while it projects modest revenue growth of about 3.5% to 3.7%. A dramatic spike in revenues cannot be expected too soon because the company will be recognizing Red Hat’s revenue only after the transaction-related adjustments associated with the acquisition run their course. Further, the revenue boost from the Z15 mainframe business will be realized from fourth quarter onwards because the company began shipping the new mainframe system in the last week of Q3 2019. Hence, two major revenue growth drivers from Red Hat and the mainframe business will only be recognized in future quarters of fiscal 2020.

Besides leveraging on its cloud strategy, IBM also is strengthening its balance sheet by improving its debt profile. In an attempt to deleverage, IBM will be winding down its OEM commercial financing operations by the end of FY 2019. The move will reduce the company’s financing debt and improve the overall credit quality of its receivables. The winding down of IBM’s financing operations will have a minimal impact on profit and the action does not change the company’s guidance for 2019. IBM also has suspended its share repurchase program to accelerate the reduction of its core debt. As a result of these actions, IBM has managed to bring down its total debt from $73 billion to $66 billion during Q3 2019. Excluding the debt related to its financing business, IBM's core debt has dropped by about $5 billion to $43 billion.

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Source: IBM Q3 2019 earnings presentation

A strong balance sheet allows the company to continue investing in flagship products like Maximo, which has gained widespread adoption within transportation, oil and gas and aviation industries. Other than Red Hat and Z15, popular IBM offerings like Maximo and TRIRIGA will continue to generate strong sales as these solutions are in high demand due to their ability to integrate with IoT (Internet of Things) devices and platforms.

Valuation

Compared to peers, IBM also looks very reasonably valued at a forward PE ratio of 10x. Only Hewlett Packard (HPE) sports a lower forward PE ratio and IBM's dividend is 4.9%, compared to HPE's 3%.

If any investors are selling losers toward the end of the year to take advantage of tax loss harvesting, IBM would be a good name to steer those funds toward.

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This article was written by

Arturo Neto, CFA profile picture
11.02K Followers
I have been involved in financial services for almost 30 years. When I first started focusing on financial planning and money management it was out of a first-hand experience watching friends and family having to work well past retirement age because they hadn't saved or invested enough. Eventually I landed in a family office worth hundreds of millions of dollars where I was able to see 'how the other half lived' so to speak. I now operate a wealth advisory firm and publish articles on Seeking Alpha for DIY investors that prefer to manage their own money. As publisher of The Income Strategist, a premium subscription service on SA, my goal is to guide investors on how best to generate income from their investments. The service includes several income portfolios with different strategies that members can use independently or in combination. As part of the service, I also collaborate with other SA authors to provide broader and deeper coverage of investing. In addition to being a Chartered Financial Analyst, I am also a Certified Private Wealth Advisor and have an MBA from the Darden Graduate School of Business at the University of Virginia. I also hold a Master of Science in Finance and Bachelors in Finance from Florida International University. Having lived in Miami almost my entire life, my family and I relocated to Nashville, Tennessee in May 2018 in the pursuit of a better lifestyle and southern hospitality. If you're ever in the area, please do reach out. I'm happy to be teaming up with the following expert analyst contributors:1. Dilantha De Silva2. The Belgian Dentist
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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: This article is meant to identify an idea for further research and analysis and should not be taken as a recommendation to invest. It does not provide individualized advice or recommendations for any specific reader. Also note that we may not cover all relevant risks related to the ideas presented in this article. Readers should conduct their own due diligence and carefully consider their own investment objectives, risk tolerance, time horizon, tax situation, liquidity needs, and concentration levels, or contact their advisor to determine if any ideas presented here are appropriate for their unique circumstances. Furthermore, none of the ideas presented here are necessarily related to NFG Wealth Advisors or any portfolio managed by NFG.

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