International Business Machines Corp. (NYSE:IBM) is one of the top tech stocks right now based on its high expected future returns. The stock has disappointed investors as it has dramatically underperformed the market for the past several years. For example, over the past nine years, the stock has remained flat while the broader S&P Index has returned 149%.
In other words, IBM shareholders have missed one of the greatest rallies in the history of the stock market. The tech giant finally seems to be at a turning point, however. Thanks to its renewed growth prospects, its attractive dividend and its cheap valuation, IBM is likely to offer a much higher return in the future than it did in recent years.
Business overview and growth prospects
IBM had a consistent growth record until 2012, but the company has failed to grow its earnings per share in the last seven years, primarily due to the transition of the information technology industry to cloud and software as a service. It is remarkable that IBM has spent about $20 billion on share repurchases in the last four years, but has failed to grow its earnings per share due to the changing business landscape.
The company, however, seems to be at a turning point right now. It just completed the acquisition of Red Hat, which is a leader in hybrid cloud, and, thus, is likely to enter a sustainable growth trajectory. IBM will accelerate the growth of Red Hat by introducing it to large clients and by expanding it in about 30 select countries. Thanks to this acquisition, IBM expects its cloud and cognitive software segment to grow revenue at a double-digit rate in 2020. In addition, the company expects mid-single-digit growth in its total revenue and high single-digit growth in its operating income in 2021 thanks to margin expansion, which will result from a shift to higher-value products and increased efficiency.
In the second quarter, IBM's currency-adjusted revenue declined 1.6%, but the company enhanced its adjusted gross margin by 100 basis points, the largest increase in the last five years. The margin expansion, which resulted from strong software revenue growth, services productivity and cloud scale efficiencies, led to an 8% increase in earnings per share. While the company is expected to post essentially flat earnings per share this year, it will likely return to growth mode next year thanks to the acquisition of Red Hat. We expect IBM to grow its earnings per share by 3% per year on average over the next five years.
IBM is currently offering a 4.6% dividend yield, which is much higher than the 1.9% yield of the S&P 500 and the yields of the vast majority of tech stocks. To provide some perspective, the Technology Select Sector SPDR (XLK) exchange-traded fund is offering a 1.3% dividend yield right now. While most tech-oriented investors dismiss IBM for its modest growth prospects, the 4.6% dividend yield is a significant component of its total return and, therefore, should not be undermined.
IBM has grown its dividend for 24 consecutive years, meaning it is poised to become a dividend aristocrat next year. Despite the lack of earnings growth for several years, the tech giant has increased its dividend at a 12% average annual rate over the past decade. However, this has caused the payout ratio to rise from 22% in 2009 to 47% this year. Therefore, it is reasonable to expect slower dividend growth in the near term. As management has raised the dividend at a 4% average annual rate in the last two years, investors should expect similar growth going forward.
Moreover, IBM will pause its share repurchases for a couple years due to the expensive takeover of Red Hat. While this may cause some concern, the dividend is undoubtedly safe. IBM has long-term service and maintenance contracts with its clients and, therefore, enjoys recurring and reliable revenues. Given the low capital expenses required in its business, IBM enjoys predictably strong free cash flows. As a result, the company is likely to continue raising its dividend for several more years.
Valuation - expected returns
IBM is trading at a price-earnings ratio of 10.1, which is much lower than the historical 10-year average earnings multiple of approximately 12. The cheap valuation can be attributed to the poor market sentiment, which has resulted from the absence of earnings growth for several years in a row.
Since we expect IBM to return to growth mode next year, we expect the market to reward the stock with a higher price-earnings ratio in the coming years. If the stock reverts to its historical average price-earnings ratio of 12 over the next five years, it will enjoy a 3.5% annualized gain in its returns.
Given all of the above, we expect IBM to offer an approximate 11% average annual return over the next five years thanks to 3% annual earnings per share growth, its 4.6% dividend and a 3.5% annualized expansion of its price-earnings ratio. Most popular tech stocks offer exciting earnings growth potential, but modest dividends and minimal potential for expansion of their valuation. IBM offers a much more balanced mix of future returns, which pass under the radar of most investors, primarily due to the modest earnings growth.
While IBM is a well-known company, it currently passes under the radar of most investors due to its disappointing performance. The company has failed to grow its earnings per share for seven consecutive years. As a result, the stock has remained flat for nearly a decade and, hence, has dramatically underperformed the market and its peers.
Thanks to its recent acquisition of Red Hat, however, IBM is likely to change course since it will become a leader in the cloud space. Moreover, thanks to its suppressed share price, the stock is offering an attractive 4.6% yield. We expect IBM to offer double-digit average annual returns over the next five years.
Disclosure: No positions in any stocks mentioned.
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This article first appeared on GuruFocus.