The woes continue for International Business Machines (NYSE:IBM). A UBS analyst downgraded IBM stock on concerns that the Red Hat acquisition would not contribute as much to earnings as anticipated.
IBM is still in the midst of a transformation from a firm focused on technology services and systems into a cloud company. This change should eventually boost IBM. The question for investors is how it will affect International Business Machines stock.
Legacy Businesses Still Weigh on IBM
UBS analyst Mujal Shah believes further declines in IBM’s legacy businesses will negate much of the drop expected from the Red Hat acquisition. Shah cites a falling backlog in the company’s global technology services, a division that accounts for about 35% of company revenue.
This causes further woes for the venerable IT company. The Oct. 15 earnings report brought the company not only a revenue miss but also the fifth consecutive drop in sales for the company. Per Mr. Shah’s concern, the 19% revenue growth from Red Hat did not make up for the revenue losses in other divisions. IBM fell by about $2 in Monday trading, taking the IBM stock price to the $133 per share range.
This shows that the transformation of IBM will come at a cost, one stockholders could end up paying. The forward price-to-earnings ratio of just 10 may attract investors hoping to find a value. However, the financials indicate it could become more like a value trap.
Investors need to consider the balance sheet. As of the end of the last quarter, IBM claimed about $17.96 in stockholders’ equity. However, the company also holds almost $57.8 billion in debt. Thanks to the $34 billion cost of acquiring Red Hat, IBM only has limited flexibility financially.
Beware the Dividend
Still, the bigger problem may lie in the dividend. In a recent article, I referred to IBM stock as a “speculative dividend play.” Unfortunately, the earnings report reiterated that sentiment. Net income for the quarter of $1.67 billion came in almost 38% below the same quarter last year when IBM earned $2.69 billion. Falling profits never help a company. This adds to a profit picture that already looks bleak. Analysts forecast that earnings will fall 7.4% for the current year and increase by 4.2% in 2020.
However, the current dividend payout ratio of 65.5% makes this earnings drop even more dangerous. With the dividend claiming so much of the company’s profits, it leaves IBM with precious little capital to further transform the company. The company will need all the help it can get as it works to establish cloud niches amid competition from the likes of Amazon (NASDAQ:AMZN), Microsoft (NASDAQ:MSFT) and numerous other companies.
IBM’s predicament also reminds me of what has happened to GE (NYSE:GE) over the last few years. GE also had to resort to a dividend cut to help fund its recovery. I do not think IBM has become as deeply troubled as the industrial giant. However, both are older companies in the midst of a transformation.
Moreover, investors need to consider the cost of not increasing the dividend. At 22 years of consecutive increases, IBM stock is only three years away from claiming dividend aristocrat status.
Some will recall that IBM stock faced a similar situation in 1993. At that time, the company cut its payout. That move helped to ultimately save the company. However, it also led to IBM stock falling an additional 20% shorter term. Investors in IBM now must face the possibility that history will repeat.
Should Investors Buy IBM Stock?
The cost of rescuing IBM may fall on investors of IBM stock. As UBS analyst Mujal Shah pointed out that for now, the company’s shrinking legacy businesses outweigh the profit increases coming from IBM’s cloud services. This signals to management and investors alike that IBM’s future lies in becoming more of a cloud company.
Investors must consider how will it get to that point. Although IBM continues to earn profits, both revenue and earnings seem stuck in a downtrend. Moreover, high debt levels leave the company with few additional options for funding.
This places further pressure on the stock due to an increasingly burdensome dividend. Not only has the dividend become more costly, but investors also have come to expect annual payout hikes. As the company saw in 1993, ending such streaks could mean more declines in a stock that has already fallen nearly 40% from its all-time high in 2013.
Bottom line, it looks increasingly likely that the cost of saving IBM looks more like it will fall on holders of IBM stock. Hence, until this value trap becomes a genuine value, investors should stay on the sidelines.
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.
