- Revenues may be sliding but margins are increasing and free cash flow levels still top $13 billion a year.
- Dollar strength, divestitures and the transition into high value products are the reasons why the top line is falling.
- IBM stock is an exciting income play at these levels. If the turnaround gains traction, they will have to keep the dividend growth rate elevated.
After another unconvincing set of earnings results, IBM stock is now trading very near the $120 handle which is an 11% decline in the share price already this year. It's hard to believe that IBM (NYSE:IBM) is now down almost $100 a share which is close to $100 billion in market cap since it topped out at almost $215 a share back in March of 2013.
However if you study IBM's decline, you will ascertain the fall in the share price is mirroring the rise in the dollar. IBM stock is down 40% since March 2013 and a whopping 32%+ since July of last year (when the dollar rally began in earnest - see chart). This makes sense to the degree that IBM receives more than half its revenue from outside the US so the strong dollar is causing havoc for the company's foreign earnings at present.
IBM's top line fell by 8.5% to $22.06 billion in its latest quarter and its net income fell to $4.46 billion which was again down significantly from the $5.51 billion the company printed in Q4-2014. It gets worse. Guidance for 2016 is adjusted earnings of at least $13.5 a share in earnings compared to $14.63 in 2015. It's obvious that the company's core business is in structural decline but its "Strategic Imperatives" division is showing promise which was up 26% compared to 2014 despite being up only 16% for the fourth quarter.
Strategic imperatives which include security, social, the cloud, mobile and analytics did $29 billion in revenue and will continue to grow aggressively going forward in my opinion (despite bearish sentiment) - especially the cloud which grew by 57% last year. The inflection point for this company will be when strategic imperatives confirm meaningful growth. Was the 16% growth level last quarter a sign of things to come or down to seasonality weakness? I think it's the latter which is why investors should be looking to start scaling into IBM stock at these levels.
Income is one of the main reason why IBM stock looks attractive right now. Most Stocks which would have suffered the collapse IBM stock has suffered over the past 36 months would have had to cut their dividends drastically. Not IBM. As a matter of fact, the company's free cash flow levels are on a par with 2013 levels ( north of $13 billion annually) which explains why the dividend pay out ratio hasn't moved that much to the upside over the last few years.
Falling revenues have not stopped IBM from rewarding shareholders through dividends and buybacks as $9.5 billion was the figure returned last year (which is still significantly below its annual free cash flow figure). IBM stock has an excellent dividend growth rate and is expected to hike its present dividend of $1.30 a share in June of this year. The present yield is 4.27% but the company should hike to at least $1.5 a share in June 2016 which would bring the yield very close to 5% assuming we are trading at similar levels in the summer. This will mean IBM will have increased its dividend for the last 21 years.
To understand the potency of using IBM's dividend growth as an income vehicle, let's go back to April 2008 when IBM stock was trading at similar levels - around $120 a share. Assuming you had invested $50,000 into IBM, the capital gain in the stock on the surface looks weak (assuming all dividends were reinvested) as the shares only rise to around $58,000. However your annual dividend cheque would have gone from $826 to $2,483 and if IBM hikes by at least 15% in June, your dividend income now would be approaching $2,900 per year.
What's the takeaway? IBM stock is trading at roughly the same price as it was in April 2008 which means you would have had no capital gains on your investment. However, your income has more than trebled. This is why you can't judge this company solely from its top line numbers. In 2008, sales were roughly $20 billion higher than present numbers. What stands out for me here is that once the stock finds a floor and earnings get back to 2013 levels, IBM stock should rise sharply to the upside. Concerning IBM and specifically income, it's all about the share accumulation and they haven't been as cheap since 2009.
Many bears refer to IBM as a dinosaur in the sense that its top line continues to decline and also with 2016 guidance suggesting that a bottom doesn't look in sight anytime soon. However, you have to delve into the company's financial statements to find out what is really going on. Firstly over $10 billion was lost last year in sales due to dollar strength and divestitures. These are areas the company had absolutely no control over as I feel it was the right decision to ditch its customer care businesses and System X as these divisions were weighing on profits. IBM, similar to Procter & Gamble (P&G) (NYSE:PG), is presently getting smaller so it can concentrate on higher margin areas which will grow the company more rapidly in the future.
IBM stock is now trading at similar valuations to what it had in the great recession of 2008. All of its valuation metrics (price to earnings, price to sales, price to book, etc) are on the floor compared to their 10 year averages. The company's income story will stay in check as long as debt levels remain subdued. If you believe the stock is going lower in the near term, you can buy it lower by selling a put option. I mention this because volatility has remained surprisingly high after its latest earnings announcement.
Puts at the moment are expensive (which is excellent for option sellers). The Feb-26th -110 put is selling for over a $1 which means that if you are exercised, you will be long the stock at $109 (strike price - credit received). High probability trade and even if you are assigned, you will be left holding a stock with a forward price to earnings ratio of close to 7 which the stock didn't even come close to in the depths of the great recession.
To sum up, IBM is suffering at the moment due to sustained dollar strength and a slow transition from its core business into strategic imperatives. However under the hood, free cash flow topped $13 billion which more than covered the company's generous dividend and share buybacks. To me, IBM stock now really sets up as income play. It has just announced an earnings beat and if earnings can get in gear, the company will feel obligated to compensate shareholders through 20%+ annual hikes in its dividend.