Linux-maker Red Hat Purchase Adds Risk to Owning IBM Stock

Big Blue needs to successfully integrate the acquisition's cloud capabilities to remain relevant

IBM (NYSE:IBM) stock continues to struggle. Since hitting highs above $215 per share in 2013, the shares have seen a steady decline. Today, the IBM stock price has fallen below $132 per share.

Linux-maker Red Hat Purchase Adds Risk to Owning IBM Stock
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Amid evolving technologies, IBM has to pivot again to remain relevant. It has attempted this feat by buying Red Hat. Investors are bailing out of the shares as integration of the Linux maker will take time. Given the time lag and the falling profits, owning the stock amounts to a gamble on whether management can successfully absorb Red Hat into the company.

IBM Stakes its Future on Red Hat

As the name International Business Machines implies, the company came to prominence by providing the “computers” that stood at the cutting edge of technology decades ago. What was once known as “Big Blue” has long since ceased to act as an innovator. Yet, it has remained relevant for decades by building businesses around technologies invented by others.

The question on investors’ minds now revolves around whether this company can reinvent itself yet again. In a software arena dominated by the likes of Adobe (NASDAQ:ADBE), Microsoft (NASDAQ:MSFT), and Alphabet (NASDAQ:GOOGL, NASDAQ:GOOG), the company faces a daunting challenge.

It took a huge leap forward in the cloud by purchasing Red Hat. As InvestorPlace contributor David Moadel wrote earlier this week, the move makes IBM a “serious contender” in the open-source software arena. Still, one can understand why IBM stock plunged following management’s last quarterly report when they told the public that Red Hat would not help boost earnings until 2021.

Where Will IBM Go Next?

This leaves investors in International Business Machines stock with two key questions: how will IBM perform while the company fully absorbs Red Hat, and will the acquisition ultimately lead to a turnaround in the shares?

The drop in IBM stock following the last earnings report means investors should expect very little of the equity for now. Revenue and profits will fall for fiscal 2019. Also, analysts only see modest growth on both measures in 2020. This makes the forward price-to-earnings (PE) ratio of 9.8x appear less appealing. Moreover, the sentiment helped to take the IBM stock price down to about $131.25 per share after Wednesday’s market carnage.

Answering the question of whether Red Hat will turn IBM around will simply take time. It has remained a force in technology years after the tech it invented became obsolete. That by itself stands as a testament to the firm’s resiliency. Still, I would not consider a comeback in IBM stock a sure thing. In truth, it has become a riskier stock than one might think.

Mind the Dividend

This danger is strongly tied to the IBM dividend. At first glance, the payout looks robust. It currently yields 4.9% and has increased for 22 straight years. The coveted “dividend aristocrat” status requires 25 years of payout hikes. However, this dividend currently eats up more than 65% of the company’s profits; that number was about 26.5% as recently as 2014.

Slashing a payout usually leads to years of stagnation for an equity. Hence, companies like to maintain these streaks if possible. In 1993, IBM reduced its dividend in a bid to save the company. Fortunately for shareholders, the dividend cuts then led to only a short-term selloff in IBM stock. Still, should Red Hat fail to turn the revenue and profit picture for IBM around, the company may have no choice but to cut the payout again. If this happens, traders should not count on a quick recovery for the stock this time.

Bottom Line on IBM stock

The near-term prospects for a recovery in IBM stock begin and end with Red Hat. Evolving technologies have hurt profit growth for the venerable tech firm. The company hopes its takeover of the Linux maker will give IBM the technology — and street cred — it needs to remain relevant.

Simply put, though, IBM stock has no obvious path to recovery without Red Hat. Moreover, the increasing cost of maintaining its dividend depends on this success. Should it cut its payout, it could suffer years of stagnation like other companies forced to surrender their dividend aristocrat status.

For now, buying IBM stock has become a gamble on the company’s success at integrating Red Hat. A favorable outcome would probably take it back to 2013 highs above $215 per share. A failure means lower dividends and a stagnant or falling stock price, possibly lasting years.

How lucky do you feel?

As of this writing, Will Healy did not hold a position in any of the aforementioned stocks. You can follow Will on Twitter at @HealyWriting.


Article printed from InvestorPlace Media, https://investorplace.com/2019/08/owning-ibm-stock-risky-bet-red-hat/.

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