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IBM Stops Buybacks to Pay for Red Hat

On July 17, International Business Machines (NYSE:IBM) reported its fourth straight quarterly revenue decline for the quarter ending June 30. Sales growth hasn’t just slowed, it’s stopped dead in its tracks. Five years ago, in 2014, IBM had revenues of $92.79 billion. This year, Big Blue will be lucky to hit $78 billion. What happened?

IBM Stops Buybacks to Pay for Red Hat

Source: Shutterstock

It hasn’t been all doom and gloom for IBM stock holders. On July 9, IBM closed on its $34 billion purchase of Red Hat, a Linux software operating system mainly used by cloud operators. IBM expects Red Hat will generate about $3.5 billion in revenue.

In a presentation to analysts on Friday, Aug. 2, IBM said it would push Red Hat’s software products to all of IBM’s top 1,100 accounts and expand it to over 30 countries. That’s great, because IBM needs a shot in the arm to boost sales and earnings.

If all goes according to plan, IBM forecasts a sales bump of 2% over the next 5 years, but it will take 2 years before Red Hat contributes to earnings.

Can IBM shareholders hold on that long?

Should You Buy IBM Stock?

While IBM’s net income last quarter came in flat year-over-year, diluted earnings per share (EPS) rose 3.4%. The reason: more share buybacks.

Big Blue spent $316 million repurchasing its stock, which contributed to less outstanding shares, giving the illusion of positive per-share earnings growth. In its last fiscal year, IBM spent over $1.2 billion to repurchase its shares!

But stock holders can’t count on that kind of “growth” any longer, as IBM said in its earnings presentation it had suspended share repurchases to pay down its debt.

What’s more, IBM’s purchase of Red Hat is still gestating, keeping net income flat. There won’t be any boost in EPS from having lower shares outstanding.

IBM also lowered its guidance for 2019 EPS to $12.80 EPS from $13.90. It is also only expecting mid-single-digit growth in sales for 2020 and 2021.

So IBM’s stock, currently priced at a price-earnings (P/E) ratio of 14.5 this year may not yet be a bargain for a year or so, until the benefits of the Red Hat begin to flow through.

IBM now has over $74 billion in current and non-current debt, including incremental debt to finance the Red Hat deal.

Prior to the deal, IBM had $46 billion in cash on its balance sheet. It used up $34 billion of that to close the acquisition, leaving it with only $12 billion in cash.

IBM said in its presentation its leverage ratio would not improve until 2020 despite shutting down its share repurchase program.

According to its recent Q2 earnings presentation, IBM generated $12.7 billion in free cash flow in the last 12 months. Free cash flow is used to pay dividends and pay down debt.

The presentation shows that IBM spent roughly $5.7 billion on dividends over the past year. Since IBM has cut out $5 billion of spending on buybacks it will have an extra $7 billion to pay for the $34 billion Red Hat deal.

So it will take about five years before the deal is fully paid for.

Bottom Line on IBM Stock

If IBM intends to stop buying back shares for the next five years, its EPS and dividend per share growth could suffer.

IBM pays $1.62 per share in quarterly dividends, which gives it an annual dividend yield of 4.66%. But IBM’s dividend was hiked only 3.2% this year from $1.57 per share each quarter last year. This compares to an increase of 4.7% in 2018 and 7.1% in 2017, according to IBM’s investor relations site.

If the Red Hat deal lowers IBM’s earnings over the next two years (and with zero share repurchases), the dividend growth will continue to slide.

So it might be worthwhile to see if IBM is really going to win with Red Hat. Meanwhile, it paid a high price for a deal that will take a number of years to filter through. I recommend watching Big Blue’s developments, but don’t buy IBM stock just yet.

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

Article printed from InvestorPlace Media, https://investorplace.com/2019/08/ibm-stops-buybacks-to-pay-for-red-hat/.

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