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

With bank accounts offering skimpy yields, bonds offering very little income, gold being just a shiny chunk of metal, and real estate being a massive headache to buy and manage, where does one go for passive income in today’s world?

Well, I believe that answer is the same as it’s pretty much been for many decades now.

The broader, more general answer is the stock market.

Specifically, a better answer might be high-quality dividend growth stocks.

Indeed, many dividend growth stocks out there offer yields of 4% or higher, along with the upside that exists when investing in wonderful businesses that are increasing profit (which is funding those growing dividends) and their business value.

Plus, that passive dividend income is growing, which is certainly not something you’re going to find with bank accounts or bonds.

The broader stock market has killed pretty much every other asset class out there over the long run.

And dividend payers and growers (per Ned Davis Research) tend to outperform the broader market itself over longer periods of time. That’s on top of the higher yields they usually offer.

More income than most other alternatives?

Check.

Income growth?

Check.

Investment value upside?

Check.

Dividend growth investing has quite literally changed my life, as saving my money and investing it in dividend growth stocks like those found on David Fish’s Dividend Champions, Contenders, and Challengers list allowed me to become financially free at just 33 years old.

I built a real-money, real-life portfolio of high-quality dividend growth stocks that’s valued at well into the six figures in the process.

This portfolio generates five-figure passive dividend income on my behalf. And that income is growing month after month.

But while this strategy is fantastic at its core, it’s not something that can be blindly picked up and followed.

Mr. Fish’s CCC list has more than 800 stocks on it.

As such, one should be filtering that list down into some of the best possible long-term ideas, considering one’s circle of competence, business fundamentals, competitive advantages, and valuation.

It’s that last part – valuation – that’s particularly germane to the discussion today.

That’s because valuation has a major impact on a long-term investment.

Price is only what something costs. But value is what something is worth.

And when you’re able to buy a strong asset when the latter is far more than the former, you’re set up really well.

That’s perhaps never more apparent than when investing in dividend growth stocks.

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

That’s all relative to what the same stock would likely offer if it were fairly valued or overvalued.

It’s pretty easy to see how these benefits are conferred when undervaluation (i.e., a price lower than value) is present.

First, it’s important to remember that price and yield are inversely correlated.

All else equal, yield will rise as price falls.

So when a price drops below fair value, the yield should correspondingly rise.

That higher yield has a positive impact on current and ongoing passive income (allowing one more “bang for their buck”).

It also positively impacts total return, as income (via dividends/distributions) is one component of total return.

The other component is capital gain, and this component is also positively impacted by undervaluation by virtue of the upside that exists between a lower price paid and higher intrinsic value of a stock.

If that value is recognized by the market, which increases the price, that results in capital gain for the investor.

And that’s in addition to whatever organic upside is possible as the business naturally becomes worth more (i.e., its intrinsic value increases) as it sells more products and/or services, increasing profit.

This all reduces one’s risk, too.

If you’re buying a static number of shares, a cheaper price means less cash out of pocket. That’s less money on the table. That’s less capital risked.

Or you’re able to buy more shares for the same amount of money.

Either way, you’re introducing a margin of safety, or a “buffer”.

If a company becomes worth less, or if it doesn’t perform as expected, you have some wiggle room before the stock’s value would fall enough to be upside down on the investment.

The last thing you want to do is pay much more than fair value, which gives you no margin of safety in case something goes wrong.

While even undervalued stocks can still drop in price and become cheaper, you have more downside protection than if you were to pay much more. And you have that additional upside potential, too.

With all this in mind, I’m always on the lookout for high-quality dividend growth stocks that appear to be undervalued.

And I have one in mind that offers a 4%+ yield right now, along with a very stout dividend growth track record…

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. They operate in over 170 countries.

As a dividend growth investor who views the safety and growth of a company’s dividend as paramount, the tech sector provides both opportunities and pitfalls.

To avoid the latter, I try to stick with large-cap firms with established global enterprises who have demonstrated an ability to constantly and successfully adapt to the inherent changes in worldwide technology.

Well, few companies have displayed that ability better than IBM.

This is a company that’s been for more than 100 years now.

As you can imagine, they weren’t into cloud computing back then. Instead, think electric tabulating machines. Computers and servers came later. IBM is now heavily investing into artificial intelligence, analytics, security, and cloud computing.

Suffice to say, IBM has shown an incredible knack for adapting its business model as technology has grown, shifted, and even radically changed.

That said, it’s not an easy process. This doesn’t happen quickly. And IBM has lately had difficulties with growing their newer initiatives (like those just mentioned) fast enough to overcome losses in legacy businesses (like hardware sales).

Still, IBM’s dividend is one of the biggest and most well-covered options in the whole market, let alone in technology.

For perspective on that, the stock yields 4.13% right now.

This was a stock that yielded less than 2% just five years ago.

Indeed, the stock’s current yield is more than 140 basis points higher than its five-year average.

So when we think of the relationship between undervaluation and increased yield, you see that playing out right here.

And the company’s dividend growth track record is one of the best in the tech space, with 22 consecutive years of dividend increases under their belt.

With a payout ratio of just 41.3%, there’s still plenty of room for more dividend increases for years to come, even if little profit growth comes to pass over the near term (as their newer growth initiatives expand to offset losses in the legacy businesses).

That payout ratio certainly supports a modest dividend growth rate, although the rather monstrous 10-year dividend growth rate of 17.5% is not a very good baseline expectation for future increases.

Instead, the most recent increase of just over 7% is probably a more reasonable baseline assumption moving forward.

But in order to really cement future expectations, and in order to estimate the value of the business and its stock, we must first look at underlying growth.

So we’ll see what IBM has done over the last decade (a pretty good proxy for the long term) in terms of top-line and bottom-line growth, and then we’ll compare that to a near-term forecast for profit growth.

Looking at this data will tell us what IBM’s done and what it might do going forward, both in terms of overall underlying growth and dividend growth, which will then help us ascertain a pretty good idea as to the valuation.

IBM’s revenue has decreased from $98.786 billion to $79.919 billion from fiscal years 2007 to 2016.

That’s obviously not what we want to see; however, it’s important to keep in mind that IBM has divested a rather significant number of businesses over this time frame. In addition, IBM’s aforementioned challenges in terms of offsetting declines in large legacy businesses adds to the revenue weakness.

Meanwhile, the company has registered rather strong profit growth over the same period, as margins have improved somewhat dramatically. Plus, IBM is one of the more prodigious companies in terms of stock buybacks.

The company increased its earnings per share from $7.15 to $12.38 over this 10-year stretch, which is a compound annual growth rate of 6.29%.

For perspective on the buybacks, IBM’s outstanding share count has been reduced by approximately 34% over the last decade, which is one of the more impressive reductions I’ve come across.

That said, the stock price has sat well above its current price for much of the period over which they were executing these massive buybacks, which is a poor use of shareholders’ capital. Hindsight is, of course, 20/20, and I believe management had good intentions with the buybacks, but the capital could have been put to better use, retrospectively.

Looking forward, CFRA believes IBM will be able to compound its EPS at an annual rate of 4% over the next three years, which is a rather large drop compared to what the company has done over the last decade.

But I believe this is a pretty fair look at things, as bottom-line growth has has moved in the wrong direction over the last few fiscal years. In fact, EPS growth has been negative since topping out in FY 2013.

However, the company’s strong free cash flow and rather modest payout ratio still leaves a well-funded dividend that has room to grow at a rate well above inflation, even absent much (or any) bottom-line growth, at least over the next 5-10 years.

The company’s balance sheet is better than the long-term debt/equity ratio of 1.90 would indicate, as the company has a large financing business that clouds its true ability to cover its debt.

The interest coverage ratio, which is over 20, shows a balance sheet that is actually quite robust.

Moving over to profitability, IBM has done a tremendous job in terms of shedding lower-margin hardware businesses in favor of focusing on and growing higher-margin businesses. While the transition has been messy, and the growth hasn’t offset losses as fast as I’d like to see, profitability – especially the improvement in profitability – is a strong suit.

Over the last five years, IBM has averaged net margin of 15.13% and return on equity of 78.01%.

ROE is skewed by the distorted balance sheet, but net margin is fairly impressive.

Consider that net margin was coming in at between 10% and 12% a decade ago.

The only concern I have here is that the upward trajectory in net margin has stalled over the last couple years. But this is, overall, a much higher-margin company today than it was a decade ago, which bodes well for the future when remembering the fact that the company is, based on revenue alone, smaller than it was a decade ago.

Overall, I consider IBM a smaller, higher-margin, more agile, and more service-focused company than it was 10 years ago.

But it’s also a weaker company in some respects, as its mainframe business allowed for significant competitive advantages that were hard for competitors to overcome.

IBM’s new businesses are in far more competitive arenas. But if there’s any company that’s demonstrated an ability to adapt and change along with technology, it’s IBM.

While the turnaround has taken longer than I would have expected, and while I think IBM itself has been surprised by the difficulty in its reconstruction, there’s still a very solid company left here.

Yet I think the market is really discounting that...

The stock trades hands for a P/E ratio of 12.05 right now. That’s about half of where the broader market is at. Furthermore, it’s a nice discount to IBM’s own five-year average P/E ratio of 12.4. Investors are also currently paying less for the company’s book value, sales, and cash flow than they usually do. And the yield, as already shown earlier, is dramatically higher than its own recent historical average.

So IBM might not be the juggernaut it used to be. But the stock certainly seems to be reflecting that. What, then, might be a reasonable estimate of its intrinsic value?

I valued shares using a dividend discount model analysis.

I factored in a 9% discount rate (to account for the yield) and a long-term dividend growth rate of just 5%.

This dividend growth rate is much lower than I’ve used in the past for the stock. But I’ve since materially lowered my expectations for the company’s dividend growth moving forward, as the turnaround is thus far not as successful as I had previously anticipated.

Still, this growth rate seems more than realistic and achievable when looking at the company’s long-term earnings growth rate, 10-year dividend growth rate, recent dividend growth, strong FCF, and modest payout ratio.

Unless IBM never grows again (which seems highly unlikely), this is a pretty low bar to clear for them.

The DDM analysis gives me a fair value of $157.50.

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.

So even lowering expectations to almost laughable level, the stock still seems pretty cheap here. It basically offers a utility-like yield with the potential for far greater long-term growth. However, my analysis is just one look at the stock, so we’ll see what some professional analysts think about the stock’s valuation here.

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 $158.00.

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 fair value calculation of $170.60.

Morningstar and I were pennies apart, which is really interesting. Averaging out the three numbers gives us a final valuation of $162.03, which would indicate the stock is possibly 12% undervalued here.

Bottom line: International Business Machines (IBM) has endured like no other in the technology space, which augurs well for their newer growth initiatives. While the turnaround is taking longer than many had anticipated, the company continues to grind out ever-bigger dividends. With a utility-like dividend that’s backed by healthy cash flow and the possibility for 12% upside, this appears to be one of the best long-term dividend growth investment opportunities in tech today.

— Jason Fieber

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