Undervalued Dividend Growth Stock of the Week: International Business Machines (IBM)

It’s difficult to be a contrarian as an investor.

When the whole world is going one way, you have to go another.

That’s not easy.

But one of my favorite quotes comes from the father of value investing, Benjamin Graham.

“The stock investor is neither right or wrong because others agreed or disagreed with him; he is right because his facts and analysis are right.”

This deference to analysis and facts is something I’ve abided by over the years.

That helped me to build the FIRE Fund, which is my real-money stock portfolio.

The Fund produces enough five-figure passive dividend income for me to live off of.

In fact, it allowed me to retire in my early 30s, as I lay out in my Early Retirement Blueprint.

Now, I don’t always get the analysis correct. And facts can change over time.

However, I’ve found that investing in world-class enterprises, especially when they’re priced correctly, is more often right than not.

That’s why I’m a dividend growth investor.

I stick to high-quality companies that pay out reliable and rising cash dividends, such as those you can find on the Dividend Champions, Contenders, and Challengers list.

After all, it takes a special kind of business to sustain growing cash dividends for years on end.

But it’s always important to do the analysis and look at the facts.

It’s also very important to consider valuation.

Price is only what you pay. Value is what you actually get.

An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk. 

This is relative to what the same stock might otherwise provide if it were fairly valued or overvalued.

Price and yield are inversely correlated. All else equal, a lower price will result in a higher yield.

That higher yield correlates to greater long-term total return potential.

This is because total return is simply the total income earned from an investment – capital gain plus investment income – over a period of time.

Prospective investment income is boosted by the higher yield.

But capital gain is also given a possible boost via the “upside” between a lower price paid and higher estimated intrinsic value.

And that’s on top of whatever capital gain would ordinarily come about as a quality company naturally becomes worth more over time.

These dynamics should reduce risk.

Undervaluation introduces a margin of safety.

This is a “buffer” that protects the investor against unforeseen issues that could detrimentally lessen a company’s fair value.

It’s protection against the possible downside.

Sticking to facts through analysis, and focusing on high-quality dividend growth stocks that are undervalued, should allow an investor to prosper over the long term.

While valuation might seem complicated, it’s really not.

Fellow contributor Dave Van Knapp demystifies it with Lesson 11: Valuation.

One of his many “lessons” on dividend growth investing, it provides a repeatable valuation system that can be applied to almost any dividend growth stock out there.

With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…

International Business Machines Corp. (IBM)

International Business Machines Corp. (IBM) is an information technology company, engaged in creating value and solving problems for clients. They provide software, hardware, and technology service solutions, along with related financing.

Founded in 1911, IBM is now a $105 billion (by market cap) global IT player, employing over 350,000 people.

The company operates across five business segments: Global Technology Services, 35% of FY 2019 revenue; Cloud and Cognitive Software, 30%; Global Business Services, 22%; Systems, 10%; and Global Financing, 3%.

What’s really impressive and unique about IBM is that it’s a technology company with a history dating back more than 100 years.

While it’s not uncommon to see, say, a consumer products company that’s been around for a century, I don’t know of any other major technology company that has been able to last this long.

Technology simply changes too much and too fast for most businesses to remain relevant.

And that’s really the crux of the matter here.

IBM has long been so investable for such a long time because of its ability to adapt.

The company has proven over and over again that it can and will shift when the time comes.

I mean, we’re talking about a business model that used to specialize in electric tabulating machines. They went from that to mainframes. That’s not a small leap.

Well, they’re now shifting once more. This time, it’s a shift to hybrid cloud and data.

In fact, they’re shifting so hard, they’re making one of the biggest moves they’ve ever made.

IBM is splitting the business and spinning off their managed infrastructure services into a new company. This is in order to streamline operations and focus on its hybrid cloud strategy after it acquired leading hybrid cloud provider Red Hat for $34 billion in 2019.

New CEO Arvind Krishna sees a very different IBM of 10 years from now than the one that existed 10 years ago.

This willingness and ability to adapt is a hallmark of IBM.

Another hallmark of IBM is paying out a large, growing dividend.

Dividend Growth, Growth Rate, Payout Ratio and Yield

In fact, they’ve increased their dividend for 25 consecutive years.

The 10-year dividend growth rate is 11.6%, but more recent dividend increases have been much smaller in nature, coming in at a low-single-digit rate.

Even with slowing growth, there’s a lot to like about the dividend.

That’s largely because the stock yields a juicy 5.53% here.

This yield is three times higher than the broader market’s yield.

It’s also more than 130 basis points higher than the stock’s own five-year average yield.

And while the payout ratio, at 73.8%, looks high, that’s more because of skewed GAAP EPS than a dividend that’s overly cumbersome.

To that point, IBM remains a free cash flow machine, and the $11.9 billion in FY 2019 FCF easily covers the dividend.

By the way, dividend growth investors shouldn’t fear the upcoming spin-off, as the combined businesses will pay “no less” than IBM’s current dividend.

Revenue and Earnings Growth

Now, these dividend metrics, while impressive, are backward-looking.

It’s those future dividends, and the future IBM, that today’s investors care most about.

We invest today’s dollars for tomorrow’s returns.

As such, I’ll now build out a forward-looking growth trajectory for IBM, which will later help us estimate intrinsic value for the stock.

I’ll partially rely on what the company has done over the last decade in terms of top-line and bottom-line growth.

Then I’ll compare that to a near-term professional prognostication for profit growth.

Blending the proven past with a future forecast in this manner should allow us to extrapolate out a growth trajectory and make some solid assumptions about IBM’s future.

The company’s revenue has decreased from $99.870 billion in FY 2010 to $77.147 billion in FY 2019.

A decrease in revenue is generally not what I like to see. And declines in some of their legacy businesses such as mainframes have been concerning.

However, IBM has also been busy doing what I mentioned numerous times already – they’ve been adapting.

That has involved a lot of divestments and jettisoned businesses, which then freed them up for the Red Hat acquisition and upcoming streamlining.

Meanwhile, earnings per share advanced from $11.52 to $12.81 (operating) over this 10-year period, which is a CAGR of 1.19%.

Admittedly, I used operating EPS for FY 2019, due to temporary impacts to GAAP EPS.

Still, even with the somewhat favorable adjustment, IBM’s growth has been far from great.

The fact that they grew the bottom line at all is a testament to huge buybacks – the outstanding share count is down by 30% over the last decade.

One could argue they should have spent less money buying back shares and instead directed that capital toward a process of adapting to the future even earlier. I wouldn’t disagree with this argument.

But IBM’s prior missteps has created the very valuation opportunity I’m discussing today, and I think management has finally made some of the big moves necessary to better position the business for what’s ahead.

Indeed, we’re all investing in what’s yet ahead. We can’t make money on yesterday’s events.

Looking forward, CFRA has no forecast for IBM’s EPS over the next three years.

This is the odd large-cap stock where CFRA currently has no EPS growth projection.

I think this might be due to the fact that IBM’s recent GAAP EPS have been unusually lumpy. In addition, the pandemic has created a lot of comparability problems.

That said, CFRA does have a forecast for near-term FCF growth.

They believe FCF will grow by 4.5% in FY 2021 over FY 2020, citing strong growth in their cloud offerings, expanding gross margin, and solid backlog trends.

On the flip side, EPS should see a boost from an abatement of recent headwinds (currency, divestitures, and non-cash adjustments).

I think a low-single-digit bottom-line growth rate (somewhat in line with recent dividend increases) is a reasonable expectation from IBM at this point, assuming the streamlining works as planned.

Frankly, that would be an improvement from some tough years of late, where the company was registering YOY decreases in profit.

And this kind of growth would be more than enough to paint a pretty picture as it relates to total return, as you’re pairing that growth with a ~5.5% yield.

Financial Position

Moving over to the balance sheet, they have an okay financial position.

The balance sheet has debt, but I don’t think it’s onerous. And the situation will look better when GAAP results bounce back.

The long-term debt/equity ratio of 2.60 looks high mostly because of so much treasury stock weighing on common equity.

An interest coverage ratio of 6.5 is good, but I think this will move higher when EBT rebounds to normal levels.

Profitability is pretty solid, although mild margin compression is a concern.

However, I’m confident this will improve after the streamlining and normalization of business.

Over the last five years, the firm has averaged annual net margin of 12.29% and annual return on equity of 61.40%.

ROE is juiced by the balance sheet, though.

There’s definitely a lot to like about IBM as a long-term investment.

The expectations are low, and the business doesn’t have to do much to surprise to the upside. This stock reminds me a little bit of where Microsoft Corporation (MSFT) stock was in 2014, just in terms of new management, low expectations, and a big move to cloud.

Meantime, investors are collecting a yield that’s about three times higher than what the broader market offers.

And with technological know-how, patents, switching costs, and global scale, there are competitive advantages in place to protect the business.

Of course, there are risks to consider.

Regulation, litigation, and competition are omnipresent risks in every industry.

Competition is particularly brutal in technology. And new competition is sprouting up all the time.

Technology also changes fast. IBM’s large size can work against them in some ways. It takes time to move a big ship like this.

The big transition to a more sticky, higher-margin hybrid cloud business appears to be a great strategy, but there is tremendous near-term execution risk. The future of the company is riding on this bet.

And with a moderately high debt load, IBM will have less opportunities in the near term to acquire or pivot.

Even with these risks in mind, I still think this stock makes a lot of sense as a long-term investment.

That thesis is backed by an exceptionally low valuation, with the stock down 25% from its 52-week high…

Stock Price Valuation

The stock is now available for a P/E ratio of 13.27.

Now, this is a stock that’s been cheap for a while – the five-year average P/E ratio is 14.5.

However, earnings have been depressed. And this is well off of where the broader market’s earnings multiple is at.

Moreover, the P/CF ratio of 6.6 is well below the stock’s own three-year average P/CF ratio of 8.5.

And the yield, as noted earlier, is significantly higher than its own recent historical average.

So the stock looks cheap when looking at basic valuation metrics. But how cheap might it be? What would a rational estimate of intrinsic value look like?

I valued shares using a dividend discount model analysis.

I factored in an 8% discount rate (due to the high yield) and a long-term dividend growth rate of 3%.

That DGR might be a bitter pill to swallow for longtime IBM shareholders who have become accustomed to generous dividend raises.

But I think the debt load, executional risk, and declining legacy businesses all point to a realignment of expectations regarding future dividend growth.

On the other hand, this is setting the bar extremely low. And if their new strategy pans out even half as well as it has for some of the competition, IBM could do very, very well.

But I’d rather err on the side of caution here. And IBM has yet to prove that the hybrid cloud plan has legs.

The DDM analysis gives me a fair value of $134.31.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.

The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.

It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.

I find it to be a fairly accurate way to value dividend growth stocks.

Even with the bar set so low, the stock still looks undervalued from where I’m sitting.

But we’ll now compare that valuation with where two professional stock analysis firms have come out at.

This adds balance, depth, and perspective to our conclusion.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.

1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar rates IBM as a 3-star stock, with a fair value estimate of $125.00.

CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.

They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

CFRA rates IBM as a 4-star “BUY”, with a 12-month target price of $144.00.

I came out right in the middle this time. Averaging the three numbers out gives us a final valuation of $134.44, which would indicate the stock is possibly 15% undervalued.

Bottom line: International Business Machines Corp. (IBM) is a technology giant that has shown a unique ability to adapt, time and time again. They’re making one of their biggest and most exciting moves ever, yet the stock is priced for terminal decline. With a 5.5% yield, 25 consecutive years of dividend raises, a well-covered payout, and the potential that shares are 15% undervalued, this looks like a rare deal in technology for dividend growth investors.

-Jason Fieber

P.S. If you’d like access to my entire six-figure dividend growth stock portfolio, as well as stock trades I make with my own money, I’ve made all of that available exclusively through Patreon.

Note from DTA: How safe is IBM’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 65. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, IBM’s dividend appears Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.