International Business Machines Corp. (NYSE:IBM) is having a rough year. While the rest of the tech sector is flying higher, Big Blue’s stock has dropped sharply. From its opening $170 level in January, shares are down about 15% on the year, trailing its peers by close to 35% on the year.
Have shares fallen enough to justify getting long? Bulls will point to the company’s ongoing incredible cash flow generation capability and capital return program. Bears, on the other hand, will argue that IBM remains stuck in a long-running and quite possibly unfixable decline. Of course, as the adage goes, there’s no such thing as a bad asset, just a bad price. Is IBM stock cheap enough to overcome its admittedly substantial drawbacks? Let’s take a look.
IBM Stock Cons
Never-Ending Revenue Decline: Wall Street likes growth. A lot. So a business that isn’t growing will have trouble getting respect from investors. IBM’s troubles look particularly bad, given that its sector has shown explosive growth since the financial crisis. IBM is seemingly well-positioned in many areas, such as cloud computing and health care software and services that are experiencing robust gains.
And yet, the company’s revenues continue spiraling downward. They’ve declined for 21 straight quarters and earned $103 billion in annual revenues as recently as 2012. That’s down more than 20% to just $78 billion over the most recent 12 month trailing period. The company can massage the decline with its massive share buyback program, but it’s hard to put a positive spin on a business that shrinks this quickly.
Warren Buffett: You shouldn’t assume that every celebrity investor always gets it right when making investment decisions. Even so, it’s hard to downplay the severity of investing guru Warren Buffett’s decision to sell part of his stake. Buffett purchased IBM stock back in 2011 and has received really mediocre returns on it, in comparison with the market and even on an outright basis.
Yet, despite that, Buffett decided to pare his stake. Why’d he do so? Earlier this year, he said that: “I don’t value IBM the same way I did six years ago when I started buying.” While acknowledging that it still is a “strong company” he suggested that the competition is greater than he had previously thought. When the long case for a stock primarily relies on the stock being a value play, having Buffett vote with his wallet in the other direction is hardly a good sign.
How Well Are Their Future Initiatives Going: IBM has plenty of positive attention and advertising campaign focused on its next-generation growth ideas. It advertises, for example, about all the things it can do with blockchain. Yet, we don’t know if they’re making much revenues off this initiative, to say nothing of profits.
Similarly, Watson has gotten so much media attention. From winning at Jeopardy to being able to diagnose illnesses, the future upside for IBM’s supercomputer seems immense. But we’ve heard the same story for many years now, so where are the revenues? At some point, the company needs to turn the promise of its cool technology into actual results.
IBM Stock Pros
Cheap Stock: IBM stock is now selling at 12x trailing earnings and less than 11x forward earnings. Given the market’s overall valuation, IBM stock is on deep discount by comparison. Even other stodgy tech companies such as Intel Corporation (NASDAQ:INTC) have recently caught a bid and moved to 52-week highs.
While anything is possible, it’s hard to imagine that IBM stock will continue trading lower while the rest of the sector moves higher. IBM now trades at both less than 10x operating cash flow, and 10x its EV/EBITDA ratio. You won’t find many large-cap US tech companies that do.
Big Dividend: IBM gets the most attention for its massive share buyback program. The company has been repurchasing stock for two decades now, causing the share count to plummet. That means that owners who have held onto IBM stock through the years now have a much larger stake in the company.
However, that’s not the only part of IBM’s robust capital return program. Big Blue stock currently yields 4.1%. That’s fairly high compared to its historical median. On top of that, it is a superstar dividend growth achiever. They’ve grown the dividend at 14% and 16% per year over the past five and ten years, respectively. A buyer of IBM stock in 2007 is now getting an 18% annual yield on their purchase price. Hold for five years more at that clip, and you get virtually all your starting capital back.
That shows, in stark relief, the danger with just thinking about IBM’s share price. Sure, the stock itself has underperformed the market. But since it can grow the dividend so quickly, things look much better from a total return perspective. If IBM keeps grinding it out, while buying back cheap stock (1ox forward earnings!) and raising the dividend, shareholders could do well. The payout ratio is still only in the 40% range, giving plenty of room for more dividend hikes.
Growth Efforts Could Work: Bears are right to say IBM has appeared to be more hype than results in recent years. So far, things such as Watson have shown potential but have underwhelmed financially.
That said, IBM has at least three promising initiatives that could return the company to outright growth and get shares rolling again. Among these, you have Watson, which could still overhaul the health care industry. The company’s blockchain efforts have the potential to make a huge score going forward. As the saying goes, in a gold rush, sell shovels. IBM looks well-positioned to profit off Bitcoin and other cryptocurrency enthusiasm.
And finally, IBM’s cloud efforts may be lagging those of Microsoft Corporation (NASDAQ:MSFT) and Amazon.com, Inc. (NASDAQ:AMZN). However, IBM clearly remains #3, and it has held steady market share as the market continues to expand. The company doesn’t need to win this outright. As long as it maintains a strong position in its niche private hosted cloud setting, the overall market is strong enough to support multiple victors.
Verdict
IBM stock is deeply unpopular at the moment. And I can see why. The company’s sales continue to decline, and it only maintains its earnings through a debt-fueled share buyback. That’s all bad news.
But I’d argue the market has overly punished the stock, particularly in comparison to its tech peers. The dividend is enough to justify owning the stock at this price. And the growth plans in the works offer a solid call option if and when they start turning into real profits.
At the time of this writing, the author owned IBM and INTC stock. You can reach him on Twitter at @irbezek.
