International Business Machines (NYSE:IBM) is facing some issues. The IBM stock price is down around 7% after releasing earnings on Oct. 16. Despite the recent acquisition of Red Hat, the company slightly missed its quarterly revenue guidance. Consensus was approximately $18.2 billion in revenue, with IBM releasing actuals of $18 billion. While the top line was disappointing, IBM had an earnings beat. Actual earnings per share was $2.68, beating consensus by two pennies.
With the add-on of Red Hat buffering revenue declines of the legacy business, what lies in store for the IBM stock price? While International Business Machines stock continues to pay a high dividend yield, there are plenty of reasons why investors should avoid it.
With plenty of headwinds and no strong catalyst, here’s why IBM stock is not a buy today:
Recent Results Impact International Business Machines Stock
Sales for the quarter ending Sept. 30, 2019 were down 3.9% from the prior year’s quarter. However, this decline can be attributed to both divested businesses and currency fluctuations. A strong U.S. dollar impacted international sales. The strong performance of Red Hat blunted these revenue declines. The Red Hat segment saw revenue growth of 19%.
Across IBM’s business units, the company saw mixed results. The Cloud segment (which includes Red Hat) saw year-over-year sales growth of 6.4%, with the segment generating $5.3 billion in revenue. IBM’s consulting unit (Global Business Services) tread water, with sales up 1%.
But the company’s other units saw revenue declines. The Global Technology Services (GTS) segment saw sales declines of 5.6%. Systems (the company’s systems hardware and software segment) saw even greater revenue declines. Sales were $1.5 billion for the quarter, down 14.7% YOY. As the company winds down its original equipment manufacturer commercial financing business, the Global Financing segment saw sales declines of 11.7%.
IBM beat on earnings, but the Street has turned negative on the company’s future prospects. UBS‘s Munjal Shah downgraded the stock to “neutral”. In his analysis, Shah believes the company’s legacy business performance will offset growth from Red Hat. A strong U.S. dollar and a lack of share repurchases are additional headwinds.
Stifel‘s David Grossman is also skeptical of IBM’s future prospects. The analyst believes International Business Machines stock remains a “show me” story going into 2020. But he may take a more positive view on IBM if the company can stabilize the GTS segment. Despite these concerns, Grossman reiterated a “buy” rating on International Business Machines stock.
With these factors at play, where is the IBM stock price headed? Looking at valuation, IBM shares may or may not be a value opportunity.
High Yield Shores up Stock Price
With tepid growth, International Business Machines stock trades at a low valuation. At first glance, IBM stock appears to be a bargain. The company currently trades at a forward price-earnings ratio of 12.5. IBM’s enterprise value/EBITDA is 11.4.
Compare this to Microsoft (NASDAQ:MSFT). Microsoft trades at 26.4 times forward earnings, and an EV/EBITDA of 18.7. But as I recently discussed, there is good reason why MSFT trades at a high multiple. Microsoft’s Azure cloud business is a solid growth driver. The company has succeeded in both organic growth and smart strategic acquisitions. On the other hand, IBM appears to be countering a declining business with high-growth acquisitions. This can help performance short-term, but long-term is not sustainable.
However, a high dividend yield will shore up the IBM stock price. IBM currently pays a 4.84% yield. The five-year growth rate for the dividend has been 10.9%. At a payout ratio of around 50%, the company can likely sustain the dividend. But with slow growth, dividend growth could cool down. As I wrote back in August, a dividend cut is a low-risk event. The company has not cut the dividend since 1993, when the company had a large-scale turnaround.
But given rising debt (due to the Red Hat deal), the company may need to engage in more aggressive debt repayment. IBM has suspended buybacks in order to reduce debt. However, if IBM faces issues growing its $12 billion in annual cash flow, something’s got to give.
Bottom Line: Take Your Time with IBM Stock
As it stands now, International Business Machines stock is not a solid opportunity. Buying Red Hat was a smart move, but the company’s legacy business remains a dog with many fleas. IBM could stabilize its legacy business. But all bets are off in terms of execution.
A high dividend yield will likely keep the IBM stock price at the current price level. But with rising debt and slow growth, the company may face issues growing the dividend. With all of this in mind, IBM stock is not a short-term buy.
Longer term, the company may prove to be a solid investment. Perhaps IBM will divest its floundering legacy businesses. But until the company makes another big strategic move, better opportunities lie elsewhere.
As of this writing, Thomas Niel did not hold a position in any of the aforementioned securities.