IBM: A Safe Dividend In This Turmoil (NYSE:IBM) (2024)

Introduction And Thesis

International Business Machines Corporation (NYSE:IBM) reported quarterly earnings yesterday. They were not bad at least in comparison to other companies. The company missed on revenue by $50 million and beat on earnings. But in my opinion, the most important point that came out of the earnings release was that IBM’s dividend is seemingly safe in this turmoil. Second, IBM likely has the liquidity to make it through the next few months without cutting or suspending the dividend.

Granted, IBM is not a growth story at the moment, and anticipated growth from the RedHat acquisition is probably pushed off a bit. On another negative note, IBM pulled its fiscal 2020 guidance. But many companies have done so. However, IBM pays a dividend yield that is over 5%. The yield was even over 6% in late-March for those who took the opportunity to add to their positions. I also like that IBM’s dividend has been raised for 24 consecutive years. It is very likely that IBM will become a Dividend Champion and Dividend Aristocrat. In my view, the stock remains a long-term buy.

Source: IBM

Impact Of Coronavirus On IBM

IBM will certainly be impacted by the coronavirus like most companies. The impact will most probably show up in Q2 2020 and possibly Q3 2020 as companies push off new purchases of new mainframes and software. In this context, Q2 2020 may not be that great for IBM. This probably explains why IBM withdrew its full year 2020 guidance.

With that said, IBM runs ‘mission-critical’ systems. Hence, IBM is in a good position to weather the storm. A fairly good percentage of IBM’s revenue at about 60% is recurring business meaning that it is not dependent completely on new sales. The company’s focus on enterprise systems gives it an edge in this environment. Further, the majority of IBM’s revenue is from financial services, the public sector, and telecommunications. These sectors are viewed as ‘essential services’ worldwide. Additionally, there has been less disruption in these sectors when compared to travel, leisure, hospitality, automotive, and energy. This is to IBM’s advantage. There is a fascination by the market on services and recurring revenue stream in IT these days. Interestingly, IBM has a hefty recurring business that has arguably gone unnoticed by the market.

IBM’s Dividend Safety

As a dividend growth investor, I am intensely concerned about dividend safety and sustainability. I have been analyzing dividend safety for stocks that I own and looking at balance sheets. I have also been looking for statements from company updates on the commitment to the dividend. In this context, IBM is seemingly committed to the dividend. From the recent earnings call transcript, the CFO has stated:

And with our share repurchase program suspended since the Red Hat acquisition, our overall shareholder payout remains at a comfortable level and we remain fully committed to our dividend, and, though to be clear, under the various scenarios we ran, we have ample free cash flow and liquidity to support our business and secure our dividend.

In fact, both the CEO and CFO emphasized several times in the conference call transcript that the dividend was secure. However, one must always take a deeper dive. But from the perspective of earnings and free cash flow, IBM’s dividend is seemingly safe at the current moment.

Earnings estimates are coming down for IBM. In fiscal 2020 guidance, IBM’s management guided for adjusted diluted earnings per share of $13.35. Now, consensus 2020 estimates are $11.67, a fairly decent cut. But even at this level, the forward payout ratio is decent at 55.5% using a forward dividend of $6.48 per share. This is below my threshold of 65%. Even if earnings come down another 10%, IBM still has a decent buffer to pay the dividend from earnings and not dip into cash on hand or issue debt.

The dividend is also safe from the perspective of cash flow. In fiscal 2019, operating cash flow was $14,770 million. Capital expenditures were $2,286 million. This gives free cash flow of $12,484 million. The dividend required $5,707 million giving a dividend-to-FCF ratio of roughly 45.7%. Now, 2020 is not going to be a normal year for IBM. If we assume a 25% hit on operating cash flow and a 15% reduction on capital expenditures then we get $11,078 million and $1,943 million, respectively. Notably, this is somewhat lower than the free cash flow of $11.6 billion in the last twelve months. In any case, my estimated dividend-to-FCF ratio is now about 51.5%. This is still below my criterion of 70% and gives IBM ample cushion if cash flow deteriorates more than anticipated.

IBM’s Balance Sheet

Much has been said about the weakness of IBM’s balance sheet. But at end of fiscal 2019, interest coverage was above 8X and the leverage ratio was bout 3.1X. These are lower and higher, respectively, than before the Red Hat acquisition but still OK values. Although I would like to see the leverage ratio below 2.5X. In addition, the company is targeting a mid-to-high ‘A’ credit rating. Note that S&P downgraded IBM to ‘A’ and Moody’s downgraded IBM to ‘A2’ after the Red Hat acquisition. But these are still investment grade ratings.

On a consolidated basis, total debt is $64.3 billion. Of this about $11,642 million is short-term debt and $52,685 million is long-term debt. But one must also separate the debt of core operations and global financing. The latter’s debt is largely offset by notes and account receivable and short-term financing receivables. From this context, the balance sheet has improved since the acquisition of Red Hat was completed. The cash position is now $12 billion, and the core debt is now $42.1 billion at the end of Q1 2020. This gives a net debt of about $30.1 billion. This is not a small value. But one has to consider that IBM is generating about $6 billion in free cash flow annually after paying the dividend and assuming no share repurchases in the above scenario. IBM can service the interest and continue paying the principal without asset sales. Alternatively, IBM can issue new debt to pay debt that matures soon.

Source: IBM Q1 2020 Earnings Presentation

IBM’s 2019 annual report provides some insight into the debt maturity profile. The chart below does not split core debt and Global Financing debt. But one can see that at end of 2019, $4,326 million matures in 2020 and $8,496 million was due in 2021 for long-term debt. Note that $2.9 billion of debt due in 2021 was redeemed after the company issued $4.1 billion of debt maturing in 8 to 20 years. The point here is that not all this debt matures at one time. Furthermore, IBM has the flexibility to pay or refinance debt due in 2020 and 2021. Hence, from this perspective, I do not view the debt as a risk to the dividend at the current moment.

Source: IBM 2019 Annual Report

Final Thoughts On IBM

IBM has been a maligned stock for several years due to the declining stock price and lack of growth. But the Red Hat acquisition, new CEO, New President, and focus on hybrid cloud should put the company back on a growth track. Although the coronavirus-induced global economic slowdown will likely delay growth initiatives, but eventually, global economies will reopen, and IBM’s customers will spend again. In the meantime, IBM pays a hefty dividend over 5% that is seemingly safe at this juncture. The list of companies that have cut or suspended their dividend due to the coronavirus, oil price wars, and transportation restrictions stands at 118 (as of April 15, 2020). I do not think that IBM will be added to the list unless business conditions deteriorate further. Hence, based on a future anticipated growth and the nice dividend yield that is seemingly safe in this turmoil, I view IBM as a long-term buy.

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