International Business Machines (NYSE:IBM) stock is cheap. Based on 2019 guidance, International Business Machines stock trades right at 10x free cash flow and a slightly higher multiple of non-GAAP earnings.
But the increasingly obvious concern is that the IBM stock price should be cheap. Declining businesses simply are not going to get much of a multiple from the market. And while IBM has managed to keep adjusted earnings per share heading in the right direction, it has done so mostly through share repurchases and, now, a significant acquisition.
That strategy can’t last forever, as investors have been reminded of late. For IBM stock to rise, IBM needs to get back to consistent, sustainable, revenue growth. Last month’s Q3 results continue to suggest that growth may take a long time to arrive — if it does so at all. And they’re another reason why at this point it’s difficult to expect much from International Business Machines stock.
The Case for International Business Machines Stock
There is a reasonable bull case for IBM stock at the moment. Again, the stock is cheap on an earnings basis; little, if any, growth is priced in at the moment. Meanwhile, IBM’s dividend yields a healthy 4.8%.
So the argument for IBM is that investors essentially “get paid to wait” for a turnaround. A continuation of recent results — with mostly flat underlying earnings — still supports nearly 5% annual returns. Any improvement, however, is not priced in, and if and when the turnaround takes hold, IBM shares can take off.
It’s not the worst case in the market, to be sure. In fact, it’s a case I myself made almost exactly a year ago. IBM stock was cheaper then, amid a broad market sell-off that wouldn’t end until the following month. But the core logic is much the same. Turnaround hopes persist, while the yield both provides income and potentially supports the stock price.
Indeed, investors have jumped into IBM stock around $130 three times in the last few months. Just below that price, the yield on IBM stock reaches an even 5%. We’ve seen other large-cap names like Exxon Mobil (NYSE:XOM) similarly get bid up at the 5% mark, which makes some sense at a time when 10-year Treasury bonds are yielding less than 2%.
At $134, IBM stock quickly is approaching that support. And so the price here might be right, or at least close.
IBM Stock Requires Growth
The problem with the bull case here, however, is the underlying business. A cheap stock and a high yield are not enough to keep a stock price afloat forever — particularly when they’re accompanied by significant debt. Widely-held names like General Electric (NYSE:GE) and Anheuser-Busch InBev (NYSE:BUD) both saw their shares plummet after cutting their dividends. Energy names like XOM and income favorite Altria Group (NYSE:MO) have fallen even while continuing to grow their payouts.
IBM bulls would likely retort that there’s little risk of a dividend cut. But investors in BUD and GE likely would have said the same thing in 2012 or 2014. IBM still is paying out half its free cash flow in dividends, and has paused its share repurchase program to pay down the debt used to fund the $34 billion used to acquire Red Hat in a deal that closed in July. If profits weaken, IBM may well need to allocate more cash to debt reduction.
And, again, if earnings decline and/or risk rises, MO, XOM, and many other stocks show that a dividend alone cannot support a stock. And while 10x earnings for IBM stock seems cheap, IBM has looked some version of ‘cheap’ for most of this decade. Yet the IBM stock price keeps heading in the wrong direction — at the same time the rest of the market has been on a ten-year-long bull run.
There’s still hope that IBM can execute its long-awaited turnaround. IBM has a legitimate cloud business, with $20 billion in revenue over the past four quarters according to the third quarter earnings release. That business grew sales 11% year-over-year in Q3. The company is a leader in artificial intelligence and blockchain, as Ian Bezek pointed out this month. Red Hat should add to the company’s cloud offering, positioning the combined company well in the so-called hybrid cloud space.
Aside from Red Hat, however, whose impact remains to be seen, the other aspects of the turnaround case simply haven’t played out yet. Growth in cloud is well below that of other major software players. It’s not even clear that IBM is maintaining share in the growing market, but cloud also erodes the company’s legacy business.
At the end of the day, this is a company that has returned to its concerning past trend: 22 consecutive quarters of declining revenue. And a cheap earnings multiple and a high dividend yield don’t offset that problem.
Rather, the converse is true. Declining revenue eventually will mean declining earnings, making IBM stock look much less cheap. That in turn will raise the risk of a dividend cut.
IBM simply has to get back to growth somehow. But with the legacy business in potentially permanent decline, and the cloud business behind those of rivals, that’s a difficult task. And with every quarter that goes by with still-negative revenue growth, that task looks even more Herculean. The fundamentals may look attractive, but IBM stock is not going to rebound for good until the business does as well.
As of this writing, Vince Martin has no positions in any securities mentioned.