- Its not all doom and gloom over at IBM. Q3 earnings showed that its GTS grew revenues to almost $8 billion. Profit margins also rose.
- Once international markets pick up again coupled with dollar weakness, IBM could very easily return to revenue growth without doing much on its part
- Use the recent SEC announcement to scale into this stock. IBM is down $10 a share since October 20th
- Income investors should avail of the attractive 3.7% yield on offer. Furthermore, I believe the stock is cheap and has the cash flows to keep rewarding shareholders even if the stock remains at these levels.
IBM (NYSE:IBM) announced earnings on the 19th of October and although most analysts continue their bearish stance on the company (due to declining revenues and net income), I see positive signs ahead of the company, especially from the perspective of income investors. IBM stock is now down almost 13% year to date (see chart) and may drop more before years end as recent guidance for FY2015 is indicating that revenue will continue to be under pressure in the near term.
However, this company is making changes internally (that many analysts are ignoring) and I'm confident these changes will bear fruit in the years to come. As a result of these changes, gross margins improved by 80 basis points to 50% in the third quarter of this year. Let's go through some recent developments at the company whilst also understanding why IBM stock, currently at $140 a share, offers a great opportunity for income investors.
Firstly, the technology services division (GTS) grew revenues by 1% (YoY) up to $7.9 billion. The return to growth was due to improved performance in security and cloud which came as a result of larger deals having been signed over the last 6 months. Furthermore, double digit growth was seen in its soft-layer business (outsourcing & integrated technology) which again looks very promising. The shift going on here is clients becoming more interested in outsourcing infrastructure and IBM can take advantage of this trend with its embedded cloud and mobile initiatives.
I think its important to point out the GTS revenue growth because all this stock has had over the last 3 years has been negative analysis because of declining revenues. I acknowledge that the stock is where it is because guidance and profits are also declining but I just feel at $140 a share, this stock is undervalued. Why? Well, firstly, even though reported revenues fell by 14% in Q3 of this year (year over year) but when you adjust the earnings for the strong dollar, the decline was a mere 1%. Also this company has been busy in divesting businesses it doesn't want any more ($7 billion of divestitures in 2014 alone) and even though I believe these business and asset sales were the right decision (because of low profits or being unprofitable), they obviously affected top line decline which we are seeing this year.
Then you have international markets like the Bric countries (Almost an 11% drop in revenues from Brazil, Russia, India & China in 2014) that have declined meaningfully in the past few years. Again the downturn internationally is something that IBM can't control and when you combine the international downturn with weaker international currencies, it was evident that the company's top line was always going to suffer especially when you consider the huge percentage of international sales this company does annually. Nevertheless, what investors shouldn't overlook is that if the bric's can turn up and the dollar weakens from here, IBM's revenues could easily grow again without the company doing much on its part. The divestitures will ultimately slow down, which should help in printing a bottom for revenue declines so the company can once again return to sales growth.
Then you have the recent SEC investigation which definitely has affected the stock adversely over the last week or so. It was ironic that on the very same day the SEC investigation was leaked, IBM authorized a $4 billion increase to its share repurchase program which now brings the total authorization outstanding to $6.4 billion. The stock has remained weak though and between earnings and now with the SEC debacle, the stock is down $10+ a share since the 20th of October. Use this downturn in the stock to go long.
So at $140 a share, do you believe this stock offers substantial upside or do you believe it is a dinosaur like so many bears would have you believe? Well, I am the former and here is why. The stock looks significantly undervalued at its current P/E ratio of 9.63. Long term investors need to look at the fundamentals over a 10 year period (see table below) and not just over the last 14 quarters where the company has had declining revenues. Let's see if the growth trends stack up for all the important fundamental metrics over a 10 year period.
|Years Of Dividend Increases||19 Years - Pass|
|Free Cash Flow||$3.4 billion (Expected Dec 2015) (10-Year Trend Is Up) - Pass (Very Important For Dividend Investors - Dividend Currently Is 3.7%)|
|Revenues||$86.9 billion (10-Year Trend Is Up) - Pass|
|Profit Margins||13% - (10-Year Trend Is Up) - Pass|
|Price History of the stock||Up 72% in the last 10 years excluding dividends - Pass|
|Healthy balance sheet||Total assets = $112 billion (10-Year Trend Is Up) - Pass|
|Resistant to recessions?||Net Income rose (see chart below) during the recession of 2008 - Pass|
Source : Macroaxis.com
Therefore the table above shows that none of the important fundamental metric have declined over the past 10 years which begs the question - why do so many analysts believe this stock is doomed just because it has had 14 quarters of declining revenues? Astute investors understand that the company is currently getting smaller (similar to Procter & Gamble (P&G) (NYSE:PG)) so it can grow quicker in the future. We can see this in its gross margin metric (currently 50%) which has risen in the past few years. This is why free cash flow levels have remained flat over the troublesome period and this is the one true metric really that income investors should be interested in.
The company has managed to achieve a dividend growth rate of almost 14% over the past 3 years which illustrates its commitment to shareholders even in the face of declining revenues. Secondly, its price to earnings and price to sales ratios have never been lower meaning you are getting the stock at a very attractive price. Do not listen to the bears that state that IBM's stock is elevated solely because of the "financial engineering" its accountants undergo. I refute this. This company has a history of rewarding shareholders. This is probably why its entry into the cloud space was slow (compared to competitors) because it put its shareholders ahead of potential revenue growth. Thirdly, its free cash flow levels are expected to be higher this year compared to 2014 even though revenues will be lesser. This is why the dividend pay-out ratio has remained small over the past 3 years. This company is a cash cow and the growing dividend in my opinion is ultra safe.
To sum up, I believe IBM stock presents an excellent opportunity for income investors here. Its free cash flow levels and high dividend growth rate will ensure shareholders get rewarded handsomely over time. Furthermore, its fundamentals are still very strong so its present 3.7% yield looks very attractive at these levels.