IBM (NYSE:IBM) has long been a key holding for many income investors. The iconic American institution has also proved to be a remarkably good investment over past decades. For years, IBM stock consistently traded higher while offering investors a growing dividend.
Source: Shutterstock In recent years, however, that momentum has stalled. IBM stock last made new all-time highs way back in 2013, despite the roaring bull market. And shares have barely advanced at all since 1999, marking a 20-year string of futility for the former tech leader.
Now, with high-profile collapses of other formerly dominant American firms like GE (NYSE:GE) and Kraft Heinz (NYSE:KHC), people are wondering if IBM will be next. Is IBM’s dividend still a reliable choice for conservative investors? Or is now the time to dump IBM stock before things get worse?
Limits of Financial Engineering
IBM has managed annual dividend hikes dating back to 1995. Not surprisingly, growth and income investors have gravitated to the stock given its compelling history. However, IBM will be unable to grow its dividend much more unless the company gets back on track. The company has a 10-year dividend growth rate of 13% annually, however this decelerated to the single digits over the past three years. Last year, IBM only offered a paltry 5% dividend hike.
The reason appears rather simple. IBM’s revenues have been declining for years. In 2011, IBM’s revenues peaked at $107 billion. In 2017, this number slipped under $80 billion, as part of IBM’s disastrous 22 straight quarters of revenue declines. IBM managed to break that streak in 2018, and achieved essentially flat revenue results for the full year. Still, this is not a good place to be, as its revenues of $79 billion are the lowest in more than two decades. Even as far back as 1999, the company was producing nearly $90 billion in annual revenues. Once you think about inflation, and how revenues should rise over time simply due to increasing prices, things look even worse.
IBM has continued to grow earnings not by improving its core business results, but, instead, through aggressive share repurchases. From the mid-1990s through 2018, IBM slashed its share count from 2.4 billion all the way to 900 million now. Through thick and thin, it kept buying back stock, allowing for steadily rising earnings even in the wake of lackluster operating results. But you can only get so far with this approach, the company’s rapidly rising debt load is making it more and more problematic to keep borrowing money to buy stock.
Increasing Dividend Skepticism
Between 1995 and the Great Financial Crisis, IBM stock never yielded more than 2%. Investors were willing to pay a premium for IBM stock’s perceived safety and reliability. In 2014, the dividend yield moved consistently over 2%. In 2015, it topped 3% for the first time in two decades.
2016 brought the dividend up to 4% at one point. Things stabilized there for awhile. In late 2018, however, IBM stock plunged, causing the dividend yield to spike to 5.8%. This showed investors had clearly lost faith that IBM’s dividend can continue at its current rate going forward. In general, only mainstream companies with essentially no growth, like telecoms, trade with dividends around the 6% mark.
IBM has done this before. In the late 1980s and early 1990s, IBM’s dividend yield steadily crept up over the 5% mark as investors lost confidence in the company’s direction. The yield kept spiking, eventually hitting 8%. In 1994, the inevitable happened, with IBM slashing its dividend. Fortunately, a management change and refocused business strategy got the company back on the right path. However, IBM very much risks another dividend cut if it can’t get revenue growth going again — and soon.
Red Hat: Make Or Break Acquisition
IBM has been making numerous purchases in recent years to try to get out of its strategic rut. IBM purchased SoftLayer a few years ago, and it became the basis for much of the current IBM Cloud. However, that acquisition has been viewed as relatively unsuccessful compared to its potential.
Analysts hold a concern that IBM simply can’t attract and retain top engineering talent, compared to more successful firms. IBM isn’t viewed as a top-tier employer like many of its rivals, nor are they able to dish out such juicy stock-based compensation to keep employees. It seems IBM needs to rework its corporate culture if it wants to remain relevant in coming years.
As such, the massive Red Hat acquisition is a pivotal moment for IBM. The company forked over $33 billion for Red Hat — that’s a massive sum, along with being a more than 60% premium to its prevailing stock price at the time of the deal. This forced IBM to take on more debt, along with suspending the stock buyback.
In return, IBM isn’t getting all that much — at least not initially. Red Hat adds just $3 billion in annual revenues to a company that already did $79 billion in yearly sales. That’s not going to move the needle in 2019. IBM needs Red Hat to keep succeeding as a subsidiary of Big Blue. But it’s unclear if Red Hat will be able to keep up its torrid growth rate if employees and clients defect from Red Hat at a high rate given the new owner. IBM’s purchase is a bold move, but one that could dramatically backfire.
IBM Stock Verdict
IBM stock certainly looks cheap enough to be a solid bargain here. At under 10 times forward earnings and with that 5% dividend yield, this is squarely in the value camp, especially in comparison with other tech stocks.
But it could well turn out to be a value trap. IBM has been relying on the share buyback to keep earnings growing and power the dividend hikes. Given the increased balance sheet risk from the Red Hat deal, IBM has had to stop the buyback. That removes the main lever IBM has had to keep shares up despite declining to flat revenues.
IBM certainly looked better in 2018, with revenues finally stabilizing. But something needs to come through, be it the Red Hat acquisition, Watson, or its blockchain initiatives to get the company returning to organic growth again. If nothing pans out within the next couple of years, a dividend cut would become increasingly likely.
At the time of this writing, Ian Bezek owned IBM and KHC stock. You can reach him on Twitter at @irbezek.
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