International Business Machines Corp. (NYSE:IBM) is a storied business. It has long been one of America’s leading brands and a mainstay of its largest companies’ IT departments. But time has taken its toll on the business. Old business lines are steadily eroding, while newer competitors have beaten IBM into promising new areas. And IBM stock has largely missed out on the bull market as a result.
But with shares cheap now, can International Business Machines stock return to being a high-flier? And growth aside, is IBM stock’s above average yield worth owning?
At least some investors think so; International Business Machines stock is surging to new 52-week highs this week. Will the rally continue?
Three IBM Stock Cons
Potentially Unsustainable Financial Model: IBM stock has held up decently over the past couple years. And it has done so due to respectable performance in its earnings-per-share number. However, that number has looked unusually strong due to IBM’s ability to buy back stock at an aggressive clip. Consider that in 2011, International Business Machines earned $16 billion in profits, which then amounted to $13.06 per IBM share. In 2015, the company earned just $13 billion, a $3 billion drop, but EPS actually rose to $13.42, a small gain versus 2011.
Unfortunately, this push may not be sustainable. International Business Machines has relied heavily on the debt markets to fuel its large dividend in addition to the massive share repurchases. It has been able to fund that debt cheaply due to persistently low interest rates.
However, the U.S. 10-year treasury bond has shot up more than 0.6% in yield since president-elect Trump’s victory. Higher interest rates would make it more expensive for IBM to continue its current debt-based share repurchases, threatening to send its EPS significantly lower in future years.
Business Culture Questions: Talk to retired or otherwise former IBM employees, and you’ll find a lot of concern about the company’s direction, particularly in innovation. The company famously ran into trouble in the late 80s and early 90s with the company having to retrench and survive a period that could well have destroyed the firm. The company overcame that stretch by aggressively seeking out new market opportunities, and investing heavily in both infrastructure and personnel to win those areas.
The International Business Machines of 2016 is potentially heading toward a similar juncture. It has relied on long-running tech and its brand prestige to keep generating profits in recent years, while ceding vast ground to more nimble entrants. You can only milk a cash cow for so long before moving on to newer pastures.
In the case of cloud computing, IBM should have been ideally positioned to grab a large share of the new market, given its entrenched position with top Fortune 500 companies. Instead, Amazon.com, Inc. (NASDAQ:AMZN) waltzed in, grabbing the pole position, while International Business Machines’ cloud business languishes with mid-single digit market share. And in the Internet of Things space, IBM stock is also not yet a leading player, aside from hopes that Watson will eventually have a big impact there.
How Long Until Watson Scales Up: International Business Machines has pitched Watson as the next big thing for the company for quite a while now. We’re coming up on a decade since the commercialization of Watson begun, and for all the excitement, it’s unclear how much it’s really benefiting IBM stock. International Business Machines doesn’t clearly break out revenues for analysts to see.
Watson is clearly ahead of the curve as far as machine learning and advanced AI goes, but it’s still more of a technology platform than a specific product. It has many uses in consulting, but it will struggle to gain wider adoption until companies can deploy it without needing to make numerous customizations specific to each different potential client use. The longer IBM hails Watson as the future without providing much detail, the more investors will conclude it’s merely a smokescreen to divert attention from the attrition in its core businesses.
Three IBM Stock Pros
Cheap Valuation
: It’s easy to paint a negative picture for IBM stock. And it’s also popular, there’s more bearishness around International Business Machines than most other big tech companies. And with negativity often comes opportunity. IBM stock is trading at around just 12x forward earnings. That’s low enough to immediately attract attention in a market trading above 20x earnings.
Even other stodgy old tech firms such as Microsoft Corporation (NASDAQ:MSFT) have seen their shares surge in recent years. It wouldn’t take a lot to change sentiment toward International Business Machines. From such a low relative starting valuation, even if it can merely stabilize its profits at a no-growth level, IBM shares should perform relatively well.
Rising Margins: Lost in the complaints about International Business Machines’ lack of business momentum, it’s easy to lose track of one of IBM stock’s best attributes: rising margins. Sure, the complaint about revenue is correct and valid. In full-year 2001, International Business Machines earned $83 billion in revenues. In 2015, it earned $82 billion in revenues. That’s not impressive over a decade-and-a-half span.
However, IBM has steadily increased its margins over that period, as it pivots from low-margin hardware sales to more profitable consulting and recurring revenue streams. In 2001, gross margins came in at 38%. In 2005, they topped 40%; 2009 brought them over 45% and 2014 topped 50% for the first time. This has resulted in International Business Machines’ operating income surging from $9.9 billion in 2001 to $15.7 billion in 2015. While growing sales would be nice, IBM is managing to earn much more off the business it does generate.
Great Dividend: While the buyback in IBM shares is the cause of great controversy, don’t overlook its other source of capital returns to shareholders. In 2001, International Business Machines paid 50 cents per share in dividends annually to shareholders. Over the last 15 years, that figure has increased tenfold. A IBM shares now yield $5.60 annually. Just since the Great Financial Crisis, the dividend has almost tripled.
IBM stock now yields 3.4%, which is one of the highest-yielding companies within the tech sector. It’s also good for the sixth-highest yield out of the 30 stocks in the Dow Jones Industrial Average. While International Business Machines doesn’t have a lot of growth going on, it does offer an above-average dividend with plenty of cash flow and balance sheet strength to back it up.
Verdict on IBM Shares
International Business Machines faces well-known complaints. The critics aren’t wrong though. IBM stock has real problems with growth, and it has fallen behind the innovation curve in several emerging tech sectors where it should be a dominant player.
That said, the negative sentiment has battered IBM shares. At this point, the company is very cheap in comparison to the broader market, offering a strong yield, and the potential for a meaningful rally if the company can generate momentum with Watson or other new initiatives.
At the time of this writing, Ian Bezek owned IBM stock. You can reach him on Twitter at @irbezek.
