Key to International Business Machines Corp. Stock Isn’t What You Think

I was just reading a Dec. 1 commentary about International Business Machines Corp. (NYSE:IBM) written by Dan Niles, founding partner of AlphaOne Capital Partners, a Philadelphia-based asset manager. 

Key to International Business Machines Corp. (IBM) Stock Isn't What You Think

Niles suggested that IBM stock is finally a buy, in part, because the company’s new z14 mainframe computer with pervasive encryption could be the mainframe dreams are made of.

“So what happened when IBM launched the new Z14 on September 13th?” Niles wrote. “IBM Z revenue grew 62 percent year over year in the third quarter after being down 33 percent year over year in the prior quarter and systems hardware revenue was up 10 percent year over year in third quarter after being down 10 percent year over year in the prior quarter.”

He goes on to say that although mainframes make up a small part of IBM’s overall revenue, the z14 could be just the tonic for IBM stock.

The Key to the Promised Land

I recommended to investors in mid-October that they ignore Warren Buffett selling a big chunk of his IBM stock and take a chance on the slow-growing, once great, tech company, so I get the desire to latch on to anything new and shiny that can lead IBM out of the wilderness.

However, as my colleague Dana Blankenhorn recently argued, analysts have good reason to be skeptical of IBM’s transformation.

“At the heart of this death is IBM’s mainframe business, a virtual monopoly since the 1950s and the object of antitrust objections since 1956,” Blankenhorn remarked. “Mainframes still have a role in banking, but the business is slowly dying, even as IBM releases new models that are fully buzzword compliant, meaning ‘AI,’ ‘cloud,’ and ‘blockchain.’”

Blankenhorn’s covered the technology markets for 35 years and, in his opinion, if you’re not growing, you’re dying.

If I were to latch on to one segment of IBM’s business that shows great promise, though, it would be its cognitive solutions segment, which generated 3.9% external sales growth YOY in the third quarter of 2017.

More importantly, the segment delivered a 32.8% pre-tax margin (70 basis points higher than Q3 2016) on $5 billion in revenue, making it by far the most significant contributor in the quarter to IBM’s profits.

Systems, the segment the z14 mainframe is part of, grew pre-tax operating profits by 149% to $339 million; while impressive, it was still one-fifth the profits from cognitive solutions.

It’s Not Technology

As I stated in my October article, the key to IBM stock has little to do with technology and everything to do with free cash flow.

Blankenhorn sees IBM as overvalued, and time could prove him right. 

I see a business that is still generating a lot of free cash flow. Maybe not as much as it once did, but until that isn’t the case, income investors ought to at least consider IBM stock for their portfolio because its 3.9% dividend yield is one of only 94 S&P 500 stocks yielding more than 3%.

Until interest rates move higher, as Niles suggested, IBM stock yields double the S&P 500 and more than the 10-year treasury yields (2.4%).

But back to my free cash flow argument…

In 2012, IBM finished the year with a market cap of $214 billion and an enterprise value of $205 billion. Its 12-month free cash flow in 2012 was $14.9 billion for an FCF yield of 7.3%

Today, IBM has a market cap and enterprise value of $143 billion and $169 billion, respectively. For the trailing 12 months, its free cash flow is $11.0 billion for an FCF yield of 6.5%.

Value investors look for 8% or higher, but given the 25% drop in its annual revenues over the last five years, 6.5% is pretty darn good.

Bottom Line on IBM Stock

As I said in my last article, IBM is doing a good job holding the line on free cash flow, which many investors consider to be the Holy Grail of financial metrics.

As long as it does that, I think it’s safe to assume that, at worst, IBM stock is fairly valued and worth considering as an investment given its dividend.

As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.

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