- Free Cash Flows of $13+ billion annually just need to increase a touch over time to keep the payout ratio under 40%.
- Watson is now being used in Formula One. IBM will keep upgrading systems to remain current.
- Security will be vital going forward. Up to 20% of enterprises will be devoted entirely to digital security in IoT by 2017.
IBM (NYSE:IBM) will have achieved over two decades of annual dividend increases when it raises its dividend again this year. IBM stock has had an excellent 2016 with the share price up over 23% over the last six weeks alone. Furthermore even with the recent rally the stock has enjoyed, the company is still trading at an earnings multiple of under 11 which is two points below its 5-year average. Dividend investors invest in IBM in spades due to its high current dividend yield (3.51%) and robust dividend growth rate (15% - 3 Year Dividend Growth Rate).
However, bears continue to insist that IBM won't be able to endure the current digital revolution it is undergoing. Analytics and its cloud computing business may be growing meaningfully but its legacy businesses are most definitely in decline as we can see from recent revenue counts. Earnings per share estimates may be lower for the coming year ($13.49) but if the stock continues to get re-rated (as it did when the Truven Health Analytics acquisition was announced), IBM could easily bounce back to its long-term average earnings multiple (12.9) which would give the company a share price of $174 assuming the company meets its 2016 estimates. Here are 3 strong reasons why I believe dividend investors will continue to get rewarded handsomely.
Firstly, before we get into how IBM is changing, let's look at the company's free cash flow versus the company's dividend payout in terms of dividend per share. Here is where bears feel they have an argument but it is one which is short sighted in my opinion. As we can see from the chart, the dividend per share has increased rapidly since 2006 - going from $0.78 per share to $5.00 a share in 2015 (over a multiple of 6). Free cash flow in this time period has gone from $11,072 billion to $13,430 billion but the float has been reduced from 1.627 billion to 961 million currently. What does this mean exactly? Well, despite the dividend rate per share going up by a factor of six since 2006, the actual dividend payout has only gone up by a factor of three ($1.683 billion in 2006 to $4.897 billion in 2015)
IBM's excellent annual free cash flow numbers (much higher than what is needed for the dividend) enables the company to buy back a lot of stock which keeps the dividend in check. However, here is the kicker. What if the company was able to increase its cash flows to a point where the dividend payout stabilized over time? At the moment, it stands at 36.8% which is double the number in 2006 but the current large investments taking place in higher growth "Strategic Imperatives" definitely gives shareholder hope for a prosperous future.
Speaking of Strategic Imperatives, IBM continues to invest heavily in cloud and data despite revenues being off over $25 billion since 2011. In fact, the company controls 7% of the market being behind only Amazon (NASDAQ:AMZN) (29%) and Microsoft (NASDAQ:MSFT) (10%). Just look at how IBM's Watson is being used in Formula One at the moment in order to monitor and analyse data. In fact, Honda is analyzing data from more than 160 sensors on its cars to try and get an edge over the competition. This is only the tip of the iceberg and it will be the first movers who will gain the most market share going forward. IBM, however, can't rest on its laurels and knows that it will have to consistently improve its data capabilities (integration, storage, etc) to build a popular brand in this space. Optevia is the latest acquisition in this space which should bolster offerings in the Customer Relationship Management (CRM) market. Sales-force controls over 18% of this market and has over 100,000 customers worldwide where more than 50% of its income comes from large companies. IBM wants to gain market share in this market through Optevia and it serves as another reminder that the company will continue to move boldly to offset stagnation in legacy divisions.
Security is another area where IBM has the potential to stand out among its peers due to the work it has already done in this division. In fact Gartner (Tech research firm) gave IBM high marks for SIEM (Security Information & Event Management) in 2015 and believes this area will grow by leaps and bounds in the years to come compared to other areas within the Security umbrella. IBM grew security to $2 billion in revenues in 2015 and with the resilient acquisition taking place recently, this should bring more value and revenue for the "Security" segment, going forward. Remember the street only needs to see a nice hike in the growth rate in this division to be in a position to value the stock higher. Security growth rates should follow the cloud and as this income will predominantly be recurring, it should add to IBM's operating margins nicely.
To sum up, IBM's dividend growth rates are not under threat despite free cash flow growth not matching dividend per share growth. I see margins continuing to expand in "Strategic Imperatives" which over time will offset negative growth in legacy businesses. Furthermore, despite the recent 20%+ rally, IBM stock is still undervalued over a 5 and 10 year period. 2016 will be interesting as it will probably be the first year when the "Internet Of Things" comes to life for many companies and IBM should be able to take advantage.