Is IBM A Sleeping Giant? 3.5% Yield And A $1.3 Trillion AI Opportunity (NYSE:IBM)

Introduction

Until last year, I’ve “never” been a big fan of International Business Machines Corporation (NYSE:IBM), as it didn’t have the capabilities to keep up with more innovative growth/tech stocks or the characteristics that I was looking for in a pure-value stock.

Over the past ten years, IBM has returned just 61%, including its dividends.

This is a horrible performance compared to the 230% return of the S&P 500, the 194% return of the Schwab U.S. Dividend Equity ETF (SCHD), and the 547% return of the Technology Select Sector ETF (XLK).

That said, on September 21, 2023, I wrote my first article on IBM, titled “The Comeback Kid! – AI-Focused IBM Is Suddenly Outperforming.”

Since then, the stock has returned 32%, beating the stellar 20% return of the S&P 500 by 12 points!

In this article, I’ll update my thesis using new developments, including AI, consulting, its juicy dividend, and the company’s valuation.

So, let’s get to it!

It’s All About AI

Artificial Intelligence (“AI”) is everywhere – everyone is talking about it. Ever since ChatGPT became mainstream, it seems the market has been focused on one thing only: finding the biggest winners of the new technology trend.

AI has become so powerful that it will be hard to estimate what the negative effects will be. For example, AI can write articles (I’m slightly worried about this), create videos and images, plan trips, program code, and so much more.

According to Bloomberg:

Making an online ad no longer requires careful staging of well-lit photographs because now they can be made and enhanced in fantastical ways. Consumers need to sharpen their wits as we move from unnaturally juicy hamburgers to depictions of people and food that aren’t physically plausible.

The picture below is a “great” example of AI possibilities and the fact that AI is not yet that great for all purposes.

Or does anyone think the picture below looks realistic? Or even tasty?

That said, the trend is what matters, which is why IBM is doing so well.

AI may very well be the life-saver that investors needed to finally own a fast-growing tech stock again instead of a high-yielding pet rock.

This is a headline from two months ago:

As reported by the Wall Street Journal (emphasis added):

Profit at International Business Machines rose as strong demand for artificial intelligence pushed revenue higher than analysts had expected.

Chief Executive Arvind Krishna said client demand for AI is accelerating. He said IBM’s book of business for Watsonx, its generative AI platform, roughly doubled from the previous quarter.

During its earnings call in January, the company noted its unique position as the only provider offering both the technology stack with Watsonx and consulting services for deploying and managing generative AI.

Essentially, the company’s consulting business is positioned as an early beneficiary of AI, with a focus on data architecture, security, and governance.

This is highly beneficial, as it offers complementary solutions and builds strong relationships with customers. To use a very basic example, if I go to a store to buy skis, they will likely try to sell me other equipment as well, including a helmet, gloves, and other stuff.

In fact, the word “consulting” was mentioned 41 times during its earnings call.

The early work for clients around data architecture, security and governance is critical and hard, and we think consulting expertise is going to be crucial here. Just as we quickly ramped a meaningful practice around Red Hat to address the hybrid cloud opportunity, we are on a similar trajectory with generative AI. Consulting is a core driver of our value proposition for clients. – IBM 4Q23 Earnings Call

Currently, software and consulting account for 75% of the company’s revenue. That’s up from 55% in 2020. Half of its revenue is recurring revenue.

Especially recurring revenue is key, as it builds earnings visibility and creates strong connections with customers.

Moreover, during last month’s Morgan Stanley Technology, Media, and Telecom Conference, the company elaborated on market share gains in consulting and higher margins, which is not a given in a challenging inflationary environment.

We grew 6% in 2023, taking share in the marketplace, a market when you look at all the Consulting competitors was probably somewhere plus or minus, flat line overall. And over a two-year period, two thirds of our way through our midterm model, we’re growing at 10%. So pretty strong performance for a couple of years overall. In addition to that, we’ve seen continued improved fundamentals in our consulting business. Our margins were up nicely over 100 basis points, both on gross and pretax — margin, pretax margin about 100 basis points overall.

Going forward, the company expects constant currency revenue growth to align with its mid-single-digit model, with expectations set conservatively at the low end of that model.

Unsurprisingly, revenue expectations are supported by solid growth projections in both software and consulting segments.

• Software revenue growth is expected to exceed the high end of the mid-single-digit model due to a strong business pipeline, innovation investments, and acquisitions.
• Consulting revenue growth is expected to be between 6-8%, with an accelerating trend throughout the year, driven by solid signings and a favorable book-to-bill ratio.

However, in infrastructure, IBM expects a decline in revenue as it enters the seventh quarter of the z16 cycle. This is expected to impact overall revenue growth by more than 1 point.

In general, during the aforementioned Morgan Stanley conference, the company noted that it believes that its potential is not fully recognized, as it expects to continue capitalizing on a “multi-trillion” total addressable market.

Using Bloomberg data, GenAI alone could become a $1.2 trillion market by 2032 and account for roughly 12% of total technology spending!

Meanwhile, free cash flow is expected to be approximately $12 billion, which translates to 6.9% of its $175 billion market cap.

Shareholder Returns

A 6.9% FCF yield is impressive, as it opens up so many opportunities for growth and shareholder distributions without the need for external funding (debt & equity).

The company went into this year with a 2.8x net leverage ratio. This is very healthy. It comes with a credit rating of A-.

This is what Fitch wrote in 4Q23 (emphasis added):

Strong FCF Generation: Fitch estimates IBM to generate annual pre-dividend FCF of over $10 billion (post-dividend over $4 billion) through Fitch’s forecast period. This results in core (CFO-Capex)/Debt ratios approaching 30% through the forecast period and continuing on an upward trajectory. The strong FCF generation provides IBM with ample financial flexibility for investments to further strengthen its capabilities around hybrid cloud and AI.

Last year, the company spent $5 billion on M&A and returned $6 billion to shareholders through dividends.

After hiking its dividend by 0.6% on April 25, 2023, it currently pays $1.66 per share per quarter. This translates to a yield of 3.5%, a yield that stands out in the low-yield technology sector.

Unfortunately, the five-year dividend CAGR is just 2.0%. The payout ratio is in the high-60% range.

While this is far from impressive, I believe IBM is making the right moves by focusing on investments instead of dividend growth.

After boosting R&D from roughly $5.5 billion in the 2016-2020 years to currently $6.8 billion, the company spends $0.11 of every revenue dollar on R&D, which should help it capitalize on the rapidly increasing total addressable market.

[…] all of our investment goes into Software, around high-value innovative solutions where we bring to market both organically with Watsonx as an example, or inorganically, where we’ve acquired, what, 39 acquisitions over the last four years. About 60% of that being in software and that plays at a hybrid platform and solutions. So that’s 70% of our portfolio. – IBM At Morgan Stanley Conference

So, what about the valuation?

Valuation

IBM “always” had a somewhat subdued valuation – at least in the past 20 years.

Currently, IBM trades at a blended P/E ratio of 19.6x, which is roughly one point below the S&P 500 P/E multiple.

Since 2003, the company has had a normalized P/E ratio of just 13.5x (the blue line in the chart below). Even during the 2008-2012 upswing, the company was valued below 16x EPS on a very consistent basis.

In fact, IBM hasn’t been this “expensive” since the early 2000s.

Growth-wise (using the data in the FAST Graphs chart above), we are dealing with expectations of consistent mid-single-digit EPS growth through at least 2026.

This year, EPS is expected to grow by 5%, potentially followed by 6% growth in 2025 and 5% growth in 2026.

Even if we apply a 16x multiple, we get a fairly valued stock, which is reflected in the consensus price target of $188 (the current price is $191).

However, I will stick to a bullish rating, as I believe the company has the right tools to deserve a better valuation over time.

Nonetheless, this puts even more pressure on the company, as there is no room for error. It needs to stay on top of AI and related services.

It also needs to boost growth in infrastructure to prevent slower segments from offsetting secular growth in other segments.

If I were long IBM, I would stay long. If I wanted to buy exposure, I would wait for a pullback, which may be likely, given that the S&P 500 has run hot in recent months.

Takeaway

IBM’s pivot towards AI has been noteworthy, propelling its stock performance and positioning it as a frontrunner in a rapidly evolving tech landscape.

With a strong focus on consulting services and a healthy balance sheet, IBM is poised for continued growth and shareholder returns.

Despite muted EPS growth expectations, I maintain a bullish outlook, as I’m confident in IBM’s ability to navigate challenges and capitalize on emerging opportunities.

Pros & Cons

Pros:

• AI Leadership: IBM’s focus on artificial intelligence positions it as a leader in a rapidly expanding market.
• Consulting Strength: The company’s consulting business, complemented by its AI offerings, strengthens client relationships and revenue growth.
• Healthy Financials: With solid free cash flow, low leverage, and a strong credit rating, IBM is in a great spot to maintain a juicy dividend with potentially elevated future growth.
• Dividend Yield: IBM’s dividend yield, standing out in the tech sector, provides attractive income potential for investors seeking stable income.

Cons:

• Moderate Dividend Growth: While offering a decent yield, IBM’s dividend growth rate has been relatively modest.
• Valuation Challenges: The company’s historically subdued valuation and modest earnings growth projections may present challenges in achieving significant capital appreciation.
• Dependency on AI and Consulting: IBM’s success heavily relies on its ability to maintain leadership in AI and consulting services.