The ongoing market correction has been particularly hard on International Business Machines (IBM) given the stock has fallen 34% off its 52-week high. That presents an opportunity to buy what I've long considered as one of the best dividend stocks on the market. In my opinion, the stock is significantly undervalued for the following reasons:
- IBM is poised to return to growth in the future based on two catalysts, the Red Hat acquisition and ongoing 'Strategic Imperatives' performance.
- IBM's consistent strong free cash flow allows it to return capital back to shareholders at a level few other companies can match.
- IBM currently trades at rock-bottom valuations. My opinion is based on historical multiples, a discounted cash flow model, and a comparables analysis. Additionally, all these approaches are consistent with Wall Street's expectations.
IBM's Financial Snapshot
IBM's performance has been mixed so far during 2018. Year-to-date operating earnings (non-GAAP) were $8.96 per share, an increase of 5% over the previous year. Revenues have also been up by 2.2%, but it has basically been negligible growth when adjusted for currency fluctuations. With that being said, IBM's "Strategic Imperatives" involving analytics, cloud, mobile, social and security are gaining more critical mass every quarter. According to the latest earnings release:
- Strategic imperatives revenue over the last 12 months was $39.5 billion, up 11% when adjusted for currency.
- Total cloud revenue over the last 12 months was $19 billion, up 18% when adjusted for currency.
- The annual exit run rate for as-a-service revenue increased to $11.4 billion, up 24% when adjusted for currency.
These strategic imperatives have helped stabilize IBM's revenue stream as it moves away from legacy hardware, software, and service businesses. If trends continue, this will return IBM to a growth company.
IBM's one major weak point is probably its balance sheet. The company is considerably more leveraged than other tech companies. I don't consider this much of an issue now, but as I'll soon talk about, IBM recently agreed to acquire Red Hat (NYSE:RHT), which is going to be funded with cash reserves and additional debt. Upon close, I'd expect that to push IBM's net cash balance to approximately negative ($66 billion).
Red Hat Acquisition
In October 2018, IBM agreed to acquire Red Hat for $190 per share in cash, which represents a total transaction value of $34 billion. The deal is expected to accelerate growth, expand margins, and increase free cash flow within 12 months of close. IBM expects to close the deal with a combination of cash reserves and debt. To help maintain a leverage profile consistent with an A credit rating, IBM will suspend its share repurchase program in 2020 and 2021.
IBM certainly paid a hefty price tag for Red Hat given the company only produced $2.9 billion worth of revenue in its last full fiscal year (IBM paid $11.64 per dollar of revenue). However, Red Hat has been growing sales at 20% per year, which IBM desperately needs. Red Hat's revenue stream is also high margin, which IBM should be able to turn into significant free cash flow after operating synergies are realized.
Strong Capital Returns
IBM is hands down one of the best dividend stocks on the market. The dividend has been delivered to shareholders uninterrupted since 1916. A falling stock price has also led to a dividend yield (5.47%) that is at its highest point over the last 20 years (you'd have to go all the way back to the early 1990s to find a time when the yield was higher). A dividend yield that's well above its historical average can sometimes indicate increased risk, but I don't believe that in IBM's case. The company's payout ratio has only been 51% this year and is generally less than 50% historically. That means that even if IBM were to continue experiencing stagnate growth, it could easily maintain the dividend or even increase it.
IBM also has been an aggressive purchaser of its own stock. I'm a fan of stock repurchases because it increases EPS even when net income remains flat, an important quality when a company is struggling for growth. Since the beginning of 2011, IBM has spent $63.6 billion repurchasing stock, which has lowered outstanding shares from 1.21 billion to 920 million shares (24% reduction). This is considerably more than dividend payments over that same period, which amounted to $35.5 billion. Stock repurchases and dividends have equaled a combined $99 billion since 2011, an astonishing figure.
IBM trades cheap based on a Forward P/E, Price/Sales, and EV/FCF. All these multiples are significantly less than peers. IBM does have a high PEG ratio given only 1% long-term growth, but I think that understates IBM's potential given its strategic imperatives and the Red Hat acquisition. I also think a higher PEG is reasonable for a reliable blue chip that provides significant returns from its dividend and share repurchase program.
Single-Stage Free Cash Flow Model
- Risk-Free Rate - I used the yield on a 30-year Treasury bond.
- Equity Risk Premium - This figure is calculated every month by Aswath Damodaran, a Stern Business School Professor.
- Beta - I used a beta of 1.15, which is higher than what I normally would use for IBM. I did this given the recent market correction and more market volatility.
- Required Rate of Return - Calculated by multiplying the Equity Risk Premium by Beta and then adding the Risk Free Rate.
- Value of Equity = CF1 / (r - g).
- CF1 = 2018's free cash flow, which I've estimated at $12 billion (this is based on IBM's guidance)
- "r" is the required rate of return and "g" is the long-term growth rate.
Based on historical valuation multiples, IBM's valuation looks mixed. Forward P/E and Price/Sales are both well below 5-year averages, but a PEG Ratio of 8.11x is high. As I mentioned above, there's a lot of reasons that don't concern me (Data sources: Yahoo Finance & Reuters):
- Forward P/E of 8.2x (5-year average of 10.5x)
- Forward PEG of 8.11x (5-year average of 3x)
- Price/Sales of 1.3x (5-year average of 1.8x)
One could argue that IBM (and the rest of the market) was overvalued over the last 5 years, which makes IBM's Forward P/E and Price/Sales multiples look cheap when they actually might not be. However, when you look at valuations over the last 15 years, you'll see that both EV/FCF and Price/Sales are at the bottom of the range. It's also important to note that the bottom of those ranges was set during the last recession, which IBM is now approaching. That's a strong indication of an undervalued stock.
Wall Street's Expectations
Wall Street's expectations for IBM are consistent with my valuation analysis. According to MarketWatch, the average price target is at $152, which represents 34% upside potential based on the current price of $113.03.
Right now is an opportunity to buy IBM at historically attractive levels. Its stock price, EV/FCF ratio, and Price/Sales ratio basically haven't been this low since the last recession. IBM's dividend yield also hasn't been this high since the early 1990s. I also believe IBM's performance is on strong footing after many years of deteriorating revenue growth. The company's strategic imperatives are performing well and should return IBM to growth once its legacy businesses continue to become less and less important to the overall business. The Red Hat acquisition will also provide a boost over the near term.