IBM to Spin Off Infrastructure Services; Dividend Investors Expected to be Kept Whole

Arvind Krishna took over as IBM's new CEO in April 2020 and has wasted no time putting his mark on the company.

On October 8, IBM announced plans to spin off its managed infrastructure services business, which accounts for about 25% of IBM's revenue. 

The spin-off transaction is expected to be tax free and close by the end of 2021. 

Once the separation transaction is completed, IBM shareholders will receive shares in the new public company (to be named at a subsequent date). 

From a dividend safety perspective, IBM expects the combined dividends from IBM and the new spinout company to at least equal the firm's pre-spin dividend per share.

Management has yet to set up a balance sheet and capital structure for the spinoff, so we don't have much financial information about how the two companies will look once split.

Based on what we know today, we are maintaining IBM's Safe Dividend Safety Score since income investors are expected to be kept whole.

Once the spinoff transaction closes, we expect IBM to lower its dividend (reflecting its loss of cash flow after splitting off infrastructure services), with the difference fully offset by dividends paid by the new spinoff company.

At that time, IBM's new dividend will likely maintain a Safe rating. The remaining business should have better growth prospects and higher margins compared to pre-spin IBM, and management expects to maintain a single A credit rating.

IBM intends to invest more in R&D and acquisition investments to improve its software portfolio, so its dividend profile could change to have a lower yield (retaining more earnings to reinvest) but stronger long-term growth potential.

We don't have enough financial information (leverage profile, target payout ratio, etc.) to fully evaluate the spinoff company's potential Dividend Safety Score.

While management wants this business to maintain an investment grade credit rating, the company also faces some growth headwinds as the technology landscape evolves (more on that later).

Given its mature profile, this new company will focus more on generating cash and returning capital to shareholders, likely sporting a much higher payout ratio than IBM.

If we had to guess, the spinoff will receive a Borderline Safe Dividend Safety Score, but we can't speculate much given the limited amount of information available today.

IBM decided to spin off this business because it did not align with management's focus on hybrid cloud and artificial intelligence.

IBM's managed infrastructure services business generates most of its revenue from project-based work to maintain and improve clients' on-premises IT infrastructure. (IBM is not spinning off services that help clients on their journey to the cloud.)

While a cash cow, this division has declined around 4% to 5% annually in recent years as more on-site infrastructure migrates to the public cloud, reducing client-based volumes.

The cloud is appealing to many businesses due to lower upfront costs (no need to purchase and manage their own mainframes and servers), greater flexibility (rent on a monthly basis), easier scaling, and faster time to market.

Spinning off the managed infrastructure services business will allow it to receive more managerial attention, hopefully improving its long-term outlook while also removing a distraction for IBM.

It's also a bit of financial engineering on IBM's part to lose a lower-margin, slowly declining business that somewhat masked the company's own cloud efforts.

Allowing investors to value each unit separately could lead to a higher overall valuation, as demonstrated by IBM's 6% price jump when the news was announced.

That said, IBM continues to have plenty of skeptics. Big Blue's revenue has yet to return to sustainable growth despite years of turnaround efforts.

Management seeks to return the post-spin IBM to mid single-digit revenue growth over the medium term by going "all in" on what it calls the hybrid cloud.

IBM believes that in the future many companies will keep some of their computing on their own servers while also migrating other programs to multiple cloud service providers such as AWS (Amazon), Azure (Microsoft), Google Cloud, and IBM's own public cloud.   

Red Hat, which IBM acquired for $34 billion in 2019, helps make that work easier for software developers by allowing them to write their code once and deploy it across various clouds. 

Following the spinoff, Red Hat will sit firmly at the center of IBM's growth strategy.

Management believes that every $1 spent on Red Hat's platform creates $9 to $13 of opportunity for IBM to sell high-margin software and services, including artificial intelligence applications, middleware, security, and application modernization.

IBM claims that 75% of enterprise workloads have yet to migrate to the public cloud, so Red Hat has a potentially long runway for growth should the hybrid cloud landscape continue playing out as management hopes. 

At the very least, IBM's vast customer base should provide opportunities for its cloud-focused infrastructure, software, and services.

IBM has served as the backbone of many corporate IT departments for decades thanks to its refrigerator-sized mainframe computers. 

These fast and powerful machines run huge jobs, such as managing the databases of an insurance company or credit card transactions of a bank.

Given the size, sensitivity, and mission-critical nature of this work, plus IBM's long-term customer relationships, these clients may be more willing to stick with IBM as they look to utilize the cloud in the future.

Otherwise, the market for cloud infrastructure and services is fiercely competitive, and IBM's sluggish growth suggests it remains far behind Amazon, Microsoft, and other rivals.

Given IBM's track record, the stock will probably remain a "show me" story until revenue trends improve. 

Red Hat, which we estimate will account for close to 10% of post-spin IBM's revenue, has continued its momentum with 18% sales growth in the second quarter. 

How long this pace of growth can continue, and how well IBM can translate it into more cloud software and services revenue, may take a few years to assess.

We will continue monitoring the performance of this key asset and IBM's spinoff plans as more information is disclosed. 

For now, income investors can know that the company intends to keep its total dividend intact as IBM refines itself for the cloud era.