IBM Remains Fully Committed to Dividend as New CEO Takes Over
International Business Machines (IBM) this afternoon reported first-quarter earnings results. So far, business is holding up reasonably well.
Management said that about 60% of IBM's revenue is in recurring businesses such as long-term services contracts, software streams, and financing arrangements. In 2008, at the last recession, annuity-like businesses only accounted for around 45% of revenue, suggesting the firm could have greater resiliency in a downturn today.
IBM also noted that over 70% of its revenue comes from industries that are expected to be "either moderately or minimally impacted by COVID-19" according to classifications from research firms IDC and Gartner. Examples include financial services, telecom, and the public sector.
Coupled with IBM's focus on large enterprise customers rather than more vulnerable small businesses, management feels good about the company's ability to weather this downturn, generate solid cash flow, and maintain its dividend.
In fact, IBM's CFO Jim Kavanaugh noted that the company ran through a number of stress tests and remains "fully committed" to its dividend thanks to the firm's solid free cash flow and liquidity:
Management said that about 60% of IBM's revenue is in recurring businesses such as long-term services contracts, software streams, and financing arrangements. In 2008, at the last recession, annuity-like businesses only accounted for around 45% of revenue, suggesting the firm could have greater resiliency in a downturn today.
IBM also noted that over 70% of its revenue comes from industries that are expected to be "either moderately or minimally impacted by COVID-19" according to classifications from research firms IDC and Gartner. Examples include financial services, telecom, and the public sector.
Coupled with IBM's focus on large enterprise customers rather than more vulnerable small businesses, management feels good about the company's ability to weather this downturn, generate solid cash flow, and maintain its dividend.
In fact, IBM's CFO Jim Kavanaugh noted that the company ran through a number of stress tests and remains "fully committed" to its dividend thanks to the firm's solid free cash flow and liquidity:
We have done a tremendous amount of work on stress testing, running these scenarios. There’s a wide range of outcomes. The key here for investors I think are two questions.
One, in any of those scenarios, do you still have the strength of your cash, your liquidity position to ensure that you can, one, invest in your business to make sure as you come out of this you can emerge stronger.
And two, can you maintain your capital allocation and your commitment to our investors and with regards to the dividend, and both of those [we answer] emphatically, yes.
IBM ended March with a cash balance of $12 billion, and another $15 billion is available through the company's unused credit facilities as backup liquidity. The company's total non-financing debt is about $42 billion.
For context, IBM generated nearly $12 billion of free cash flow last year, and its dividend costs about $5.7 billion annually. The business remains on solid financial ground from a liquidity perspective.
As has been the case for years, the bigger challenge is growth. IBM's revenue declined at a low single-digit pace again last quarter, continuing a multiyear trend.
Earlier this month Arvind Krishna took over as IBM's new CEO, replacing Ginni Rometty. His focus is returning the company to growth.
Mr. Krishna has spent nearly three decades with Big Blue, according to Reuters. He worked in IBM's Watson division for nearly 20 years and most recently headed up the company's cloud-computing business.
Mr. Krishna will have a profound impact on IBM's future. He was known as the "principal architect" of IBM's largest acquisition ever, Red Hat, which was acquired for about $34 billion in a deal that closed in July 2019.
On the call, Mr. Krishna said that about half of IBM's business has changed in the last five to seven years, and he indicated that a similar pace of change could be expected over the next five years.
He plans to further focus IBM on hybrid cloud computing and artificial intelligence while continuing to shift away from less profitable businesses such as IT services, consulting, and hardware.
Acquisitions are expected to continue playing an important role, and Mr. Krishna said that size is no issue given IBM's strong balance sheet.
Prior to acquiring Red Hat in 2019, IBM maintained low leverage. Even after taking on a significant amount of debt to fund this transaction, IBM's balance sheet remains solid and earns an A credit rating from Standard & Poor's.
However, depending on the size of future acquisitions and trends in legacy businesses, IBM may only have one or two more substantial shots to get the right pieces it needs before its financial flexibility becomes more limited.
Investors will need to trust Mr. Krishna's capital allocation skills.
He believes many companies have yet to migrate to the cloud, but when they do, they will opt to keep some of their computing on their own servers while migrating other programs to various cloud providers.
Red Hat helps make that work easier for software developers, and IBM's substantial scale provides opportunities for Red Hat to gain new business quickly. (Red Hat's sales grew 18% last quarter.)
Back when the Red Hat acquisition was announced in 2018, we discussed IBM's cloud strategy and the value it sees in Red Hat. Please review our note here for more information. Future acquisitions seem likely to align with this strategy.
For now, we expect IBM to maintain its Safe Dividend Safety Score thanks to its consistent free cash flow generation and conservative financial profile. However, the path to profitable long-term growth won't be easy, and we generally prefer to invest in businesses that operate in markets with a slower pace of change.
Overall, it will take time for Mr. Krishna to leave his mark on IBM. The dividend should remain reliable for the foreseeable future and expectations continue looking low, but IBM's business will likely evolve significantly over the next five years, for better or worse.
