Right now ExxonMobil Corporation (NYSE: XOM) and International Business Machines Corporation (NYSE: IBM) are offering yields of 4.7% and 5.5%, respectively. Each is more than twice what you'd get from an investment in an S&P 500 Index fund. The only problem is that the companies both have some negatives attached to them.
Here's why you should be looking at them anyway.
1. This oil giant has legs
The big knock against Exxon is that it drills for dirty carbon fuels. The world is moving away from these energy sources, and that is going to make the company an obsolete dinosaur. This view is totally justified, with renewable power and electric cars both quickly gaining scale. But there's a long way to go before the world can simply say goodbye to oil, natural gas, and all of the other products made from these fuels. In fact, the International Energy Agency expects oil demand to continue to grow until at least 2040, with demand for natural gas increasing materially over that span. Equally important, oil and natural gas are depleting resources, so new drilling will be needed to meet that demand.
Image source: Getty Images
In other words, oil and gas are here to stay for a very long time. Exxon, meanwhile, has the staying power to be a big player. For starters, it has a diversified model that spans from the upstream (drilling) to downstream (refining and chemicals) businesses. That gives its top line a little balance, since falling oil prices mean lower costs for its downstream operations, which count oil as a key input. The company also has the lowest leverage of its peers, with long-term debt below 10% of the capital structure. Exxon also has a rock solid balance sheet, a real asset when dealing with the often volatile price of oil.
Another big concern about Exxon right now is that production has been falling for the last couple of years. But the company is working on that, and, as just noted, has the financial strength to see its plans through no matter what happens to the price of oil along the way. Moreover, it looks like the company hit a key inflection point in the third quarter, with production growing sequentially from the second quarter. The key driver was an increase in production from Exxon's onshore U.S. drilling efforts, which is just one of several projects it has in the works. If you can think long-term, financially strong Exxon is worth a close look from dividend investors today.
2. It's a big acquisition, but not that big
The next company dividend investors should look at, IBM, requires a little more faith. This global technology giant has seemingly fallen behind the times in the technology industry, and its efforts to catch up have been slow at best. And now it's looking to buy Red Hat, Inc. (NYSE: RHT), an expensive $34 billion acquisition, to help speed up its shift toward on-trend tech businesses.
There's no way around it: IBM has been struggling lately. However, there are a few facts to consider here before moving on. For starters, IBM is not a consumer-facing company -- it serves businesses. And it has a long list of big name customers. While consumer-facing technology names make the headlines, IBM quietly brought in over $80 billion in revenue over the last 12 months, generating $12.7 billion in free cash flow. Dividends over the last four quarters only ate up around $5.6 billion in cash (about 45% of free cash flow), leaving plenty of money around for other things. This is not a company that is struggling to survive, or one that is having a hard time covering its dividend.
And, while the business shift has been slow, IBM is at an inflection point where new businesses are starting to contribute as much, or more, to sales than old businesses. That suggests that growth could finally be around the corner. Adding Red Hat should help with this shift.
But what about the Red Hat deal? There's clearly a hint of desperation in a struggling old-line company making a giant acquisition. For starters, IBM is well versed in the technology that underpins Red Hat's business. This is not a case where a dying company is taking on a totally new line of business. Second, the deal isn't as large as it seems: Red Hat's revenues over the past 12 months were around $3.3 billion, tiny compared to IBM's top line. So integration probably won't be that big a deal. Meanwhile, Red Hat is considered a well-run company that has been growing strongly.
Buying Red Hat will be expensive, but it looks like IBM can handle it. Long-term debt makes up around two-thirds of IBM's capital structure, which is a lot -- and when you add in the debt that will be needed to fund the Red Hat deal, leverage becomes a big concern. In fact, IBM has stated that following the deal it will stop stock buybacks so it can put that cash to work paying down debt.
But there's another issue here: A lot of the debt on IBM's balance sheet is tied to its financing operations. The company's total long-term and short-term debt is roughly $47 billion combined, but pull out debt tied to financing -- which is taken on in support of sales -- and IBM only has about $16.5 billion in long-term and short-term debt. The leverage picture looks a whole lot better when you dig in a little bit, which makes the cost of the Red Hat deal seem a lot more manageable.
In order to jump in here and get that over-5% yield, you need to believe that IBM will turn the ship. However, with an over-100-year history of adjusting with the times, that's not necessarily a bad bet. For income investors willing to think long-term, IBM is worth a deep dive today.
Opportunity in tough times
It would be a lie to suggest that Exxon and IBM are hitting on all cylinders today. They are giant, financially strong companies that are working to adjust to the changing tides in their respective industries. But they both look like they have the wherewithal to do it when you dig in a little past the dour headlines. If you can look past today's troubles, both are offering generous dividend yields for income investors.
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