Can IBM Keep Its Dividend Growing?

• Free cash flow levels are still healthy at IBM so dividend growth should continue in the near term.
• Strategic Imperatives continue to impress.
• Debt levels must be watched especially with multiple acquisitions on the horizon.

International Business Machines Corp. (NYSE:IBM) is currently trading at $160 a share with an earnings multiple of just over 13. From my calculations, IBM is now trading at its 5-year average price to earnings ratio of 13 and just slightly above its 10 year average of 12.8. However, investors (especially dividend investors) seem anxious to take profits as downside risks seem to be in play, because of the 40%+ move since February. I remember the same happening to Facebook Inc. (NSDQ:FB) when article after article was bearish due to the company’s huge earnings multiple. In fact, Facebook analysts have gone from bearish to bullish as the Facebook stock has gone from strength to strength.

With respect to IBM, the stock only is now trading at its 200 week moving average which illustrates to me straight off the bat that this stock is not overpriced. Many investors forget where this stock has come from (well north of $200 a share) and the risk one runs now is getting left behind if one liquidates their position. When evaluating a dividend play, I research free cash flow levels, the company’s fundamentals, valuations and financials. We already have touched on valuation so let’s bring in the other big three factors to ascertain whether Big Blue remains a buy for long term dividend growth investors.

Free Cash Flow Margins Are Rising

First things first. Free cash flow is what funds dividends, not revenues or earnings. Top line sales may still be dropping (down around $20 billion annually since 2013) but free cash flow on a trailing twelve month basis is up by over $1 billion to $14.34 billion. Now, last quarter the company did $2.51 billion in net income and paid out $1.34 billion in dividends, giving a dividend payout ratio of 53%. This has worried investors as the 53% figure is above the norm for the company. However, the free cash flow per share metric has never been higher and reached $13.82 per share last year, which is higher than when the company was doing $106 billion+ in revenues in 2011. Therefore, dividend investors should be looking at free cash flow margin levels which is basically free cash flow as a percentage of revenue instead of other metrics. Incidentally, free cash flow margin is up 3%+ so far this year which illustrates to me that dividend growth is not going to slow down anytime soon.

Strategic Imperatives Continue To Grow By Double Digits

In terms of fundamentals, IBM continues its shift to strategic imperatives which, as a group, grew by double digits in the second quarter. The crux of the issue is whether strategic imperatives can record positive growth over a sustained period and whether this growth can outpace the declines we are seeing in the legacy section of the business. If we group together the last 4 quarters and average them out, strategic imperatives now account for 38% of the company’s revenue (or $30.7 billion) which means the $40 billion 2018 target still seems very much attainable. I have no doubt that through acquisitions and partnerships, strategic imperatives will continue to grow for the company but risks remain, which investors should be aware of. Firstly, integration risk has to be a factor in this fiercely competitive market. Cisco Systems, Inc. (NSDQ:CSCO) recently reported how it will use savings from impending job losses to aggressively invest in cloud technology.

IBM Has Fierce Competition In The Cloud Space

Expect IBM to keep its feet on the floor regarding acquisitions. It has to make sure it doesn’t overpay or its balance sheet could take a turn south very quickly. Furthermore, IBM did very well with the legacy side of its business in the past because of the high switching costs. Will there be meaningful switching costs on the software side of the business? Will IBM be able to hold its own against the likes of Amazon & Microsoft in the cloud space? Again where investors will see the first signs of trouble will be free cash flow numbers. The margins are there at present but must be watched carefully in forthcoming quarters.

Can IBM Continue To Increase Dividend By 15%+ Per Year?

In terms of the company’s financials, its long term debt levels are rising. Currently Big Blue has a debt to equity ratio of 2.52 which is more than double of what it was in 2011. Cash levels are shrinking which must be a slight worry considering the amount of acquisitions IBM must undertake in this space to stay competitive. Furthermore, and aside from the high dividend yield, dividend growth rates are a big reason why income investors invest in this company. IBM’s 12 month growth rate is a whopping 15% and 10 year growth rate is 18.7%. So the question is can IBM continue to increase its shareholders income by 15%+ every year as well as invest heavily in its future? We will know soon enough.

Summary

To sum up, IBM’s second quarter showed that its strategic imperatives are still growing strongly. The stock is still not overvalued in my eyes and free cash flow levels and margins continue to grow. Nevertheless, dividend investors will be mindful of growth rates as well as the company’s debt balance. All of these metrics could affect dividend growth rates going forward.