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

Growing one’s wealth and passive income is such a simple and straightforward process, it almost boggles the mind that more people aren’t financially independent.

But I think the dearth of financial education in the USA might have something to do with this.

In fact, I’m a great case study.

Nobody (parents, teachers, etc.) ever sat me down and told me a thing about money, how to budget, investing, compound interest, or anything else that is almost vital toward living a healthy, happy, and sustainable life.

And so I just went about my life ignorant to money.

I worked to earn and earned to spend. I invested nothing. And I bought things I didn’t need with money I didn’t have.

Finding myself overworked, overstressed, and below broke in my mid-20s was sobering.

Being let go from my job during the depths of the financial crisis was the lowest financial point I’ve ever experienced in my life.

But it forced me to wake up and get a handle on my finances.

Unfortunately, I had to educate myself. And I had to change everything all alone.

That’s just how it is in the States.

And that’s what today’s article is all about.

The information contained herein is designed to inspire you to help and improve yourself. 

Because nobody is going to do it for you. Nobody will care more about your money than you.

See, growing your wealth, passive income, freedom, and options in life is not a particularly complex idea.

But it does require a person to take action for oneself.

To prove that point, I spent six years of my life doing something incredibly simple: I lived well below my means and invested my excess capital into high-quality dividend growth stocks like those you’ll find on David Fish’s Dividend Champions, Contenders, and Challengers list – a compilation of more than 800 US-listed stocks that have raised their dividends each year for at least the last five consecutive years.

Nothing difficult. Nothing impossible. But it required action on my part.

The end result?

Financial independence, underpinned by the five-figure and growing passive dividend income my real-money and real-life dividend growth stock portfolio generates on my behalf.

That portfolio was built one high-quality dividend growth stock at a time.

I just focused on world-class businesses that have a measurable record of paying increasing dividends to their shareholders, because growing dividends don’t fund themselves. And I bought these stocks when the valuations were appealing.

A business has to do a lot of things right (like increase profit) over the long haul in order to sustain growing dividends.

As such, a lengthy track record of growing dividends is usually a very good litmus test for business quality. 

And that growing dividend income can be used to compound one’s investment during the build-up phase, whereby growing dividends buy new shares that are also paying growing dividends. It’s growing dividends buying more growing dividends.

Plus, increasing dividend income is an excellent source of passive income. 

You don’t have to do anything for it. No phone number to call. No letter to write. Nobody to bother. The money just shows up in your brokerage account. It’s fantastic.

But a high-quality dividend growth stock should be purchased when its valuation is appealing. 

Said another way, you want to buy it when it’s undervalued – when the price is materially below estimated intrinsic value.

That’s because this confers a number of benefits to the long-term investor.

An undervalued dividend growth stock should give an investor a higher yield, greater long-term total return potential, and reduced risk.

It’s fairly easy to see how that all plays out.

Price and yield are inversely correlated. So all else equal, a lower price will result in a higher yield.

That higher yield should not only mean more income in the immediate and short-term sense, but it should also positively and dramatically affect long-term aggregate dividend income.

It’s a higher yield on the investment which is a direct impact on income. But every dividend increase going forward will also be based on that higher yield. So it’s a huge win-win for income.

But it gets better, because that higher yield also boosts long-term total return potential, as yield is one of two major components of total return.

Capital gain, of course, is the other component.

And capital gain benefits in its own way, via the “upside” that exists between a lower price paid and higher intrinsic value of a stock.

If a stock that’s worth $50 is bought for $30, there’s $20 worth of upside that would result in excess capital gain if/when the market more correctly prices that stock.

And that capital gain is on top of whatever organic capital gain is possible as a business does its thing and becomes worth more as it earns more money.

All of this also reduces an investor’s risk, because it’s less capital on a per-share basis that’s risked upfront.

In addition, one builds in a margin of safety if they pay much less than estimated fair value, which helps protect an investor’s investment and downside in case the fair value estimate is wrong, or in case a business impairs its fair value by doing any number of things wrong.

Undervaluation can make a good investment a great investment.

Fortunately, the process of valuation isn’t terribly difficult.

Fellow contributor Dave Van Knapp has greatly simplified this for dividend growth investors by producing a “lesson” on valuation, which is part of an overarching series of articles that educate both novice and experienced investors alike on exactly what dividend growth investing is, how it works, and how to successfully implement it over the long run.

Maybe society has failed you when it comes to financial education and inspiration.

However, we’re here to make up the slack a little bit.

With that said, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…

International Business Machines Corp. (IBM)

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.

IBM, affectionately known as “Big Blue”, is about as blue chip as they come, especially when talking about the technology sector.

They’ve shown an ability to repeatedly adapt to global changes in technology and trends, coming out stronger for it in the end.

With a corporate history dating back to 1911, where they originally focused on electric tabulating machines, their time-tested business is like no other in existence.

That said, they’ve been tested and then some recently, with a significant change in how companies compute, access and store data, and think about processes radically changing in a very short period of time, which has dramatically reduced demand for IBM’s once-impenetrable mainframe business.

But IBM has responded to the challenge with heroic effort, moving swiftly and decidedly into cloud computing, security, analytics, and artificial intelligence.

However, this shift takes time – perhaps more time than even IBM thought.

And so sales within their “strategic imperatives” (the aforementioned cloud and software businesses) has had a difficult time keeping up with the losses within their legacy businesses (like hardware sales).

That said, the company remains a massive player in the tech space. And the strategic imperatives now make up almost half of the company’s total revenue.

Meanwhile, the dividend is big, reliable, and growing.

For perspective on that, the stock yields a massive 3.84% right now.

That’s up there with some utilities an REITs, which says a lot. It’s also more than 70 basis points higher than the stock’s five-year average yield.

Plus, the dividend growth that comes along with that big yield is mightily impressive: the 10-year dividend growth rate is a stout 14.7%.

There has been some marked deceleration in dividend growth, which is to be expected while the company transitions. But the combination of yield and dividend growth is still in the double digits, which is very appealing.

The dividend is very healthy, as evidenced by the payout ratio of 43.5% (based on adjusted FY 2017 earnings per share).

And since IBM has increased its dividend for 22 consecutive years, it seems highly unlikely that the dividend will stop growing anytime soon.

But in order to build an expectation for future dividend growth, we must look at what kind of overall growth the company is actually generating.

Since the dividend will be funded by the profit and cash flow of the business, we must look at the growth there in order to make a call on future dividend growth, which will also help us value the business.

We’ll first look at what IBM has done over the last 10 years, using that as a proxy for the long haul.

And we’ll compare that to a near-term professional forecast for EPS.

Blending the known past and estimated future in this manner should allow us to build a reasonable base case for what IBM might deliver going forward.

IBM’s revenue is actually down from $103.630 billion in fiscal year 2008 to $79.139 billion in FY 2017.

That’s due to the changing dynamics across the industry and IBM’s business model.

While the change from hardware to software, services, and solutions has been more of a challenge than an opportunity for IBM thus far, the good thing about this shift has been that IBM has largely been able to expand its margins over much of this period. However, the last couple fiscal years have seen that trend unfortunately reverse.

The company’s earnings per share grew from $8.93 to $13.80 over this period, factoring out a one-time charge of $5.5 billion in FY 2017 due to US tax reform. That’s a compound annual growth rate of 4.95%.

That’s certainly better than what the top line has done over this same time frame, but it’s also not particularly impressive.

It’s thanks to a massive share buyback program that IBM has registered so much excess bottom-line growth, with the company reducing its outstanding share count by ~32% over the last ten years.

The picture is mixed here, and we have to keep in mind that IBM is still turning the ship.

A number of numbers indicate that they’re finally starting to see some success, though.

The strategic imperatives now make up almost half the company’s revenue, and it was that side of the business that grew 11% YOY in FY 2017. Cloud alone grew 24% YOY. Things are working.

However, this turn has taken a lot longer than most (including IBM itself) likely would have thought. And it remains to be seen whether IBM will ever again be a dominant force in tech.

Looking out over the next three years, CFRA is predicting that IBM will compound its EPS at an annual rate of 5%.

There’s nothing surprising about this; we’re looking at a forecast that assumes the status quo.

But I believe there’s actually room for IBM to surprise investors with even better growth moving forward, as it seems that they’re finally turning the corner after bottoming out.

Moreover, IBM has been heavily investing in AI, quantum computing, and blockchain technology in recent years, which positions the company well as we enter a new era of tech.

For perspective on IBM’s future as IBM sees it, the company released an investor briefing just a few days ago that calls for EPS growth in the high single digits over the long run. The company also noted that it’s committed to increasing the dividend every year.

The balance sheet looks worse than it is due to the way the company finances some of its sales, but the company remains in great financial shape.

The long-term debt/equity ratio is 2.26, which is high. But the interest coverage ratio, at over 19, is very healthy. In addition, cash and cash equivalents add up to almost 1/3 the long-term debt.

Profitability has long been a strong suit for IBM, with margin expansion in recent years just bolstering their case.

But with that margin story losing traction recently, there remains something to be desired here.

Still, the company averaged annual net margin of 13.55% and average return on equity of 70.92% over the last five years – and that’s even with factoring in a very off FY 2017 (due to a massive one-time tax-related charge to GAAP EPS).

So this remains a very strong and relevant company.

Now, the company’s turnaround story has taken longer than I certainly believed it would. And the company still faces competition, regulation, and obsolescence risks There are still plenty of unknowns when it comes to what kind of company this will be a decade from now.

But at the right valuation, this stock could be a great long-term investment for a dividend growth investor, especially considering the company’s continued commitment to dividend increases.

Is the valuation currently at that right level? 

The stock is trading hands for a P/E ratio of 11.54 (using TTM EPS that factors out the Q4 tax charge). That’s less than half the broader market’s P/E ratio. And it’s even below the stock’s own lowly five-year average P/E ratio of 12.1.

And the yield, as shown earlier, is significantly higher than its own five-year average.

The stock looks cheap at first glance, but how cheap might it be? What would a reasonable estimate of its intrinsic value look like? 

I valued shares using a dividend discount model analysis.

I factored in a 10% discount rate and a long-term dividend growth rate of 6.5%.

That long-term DGR is obviously well short of the company’s track record (both in the short-term and long-term sense). And the moderate payout ratio, management vision for long-term EPS growth, and company commitment to dividend growth all look great.

But the I’m also considering the 10-year EPS growth rate, the deceleration in dividend growth, and the forecast for near-term EPS growth.

The DDM analysis gives me a fair value of $182.57.

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 my perspective is that the stock is roughly fairly valued.

To be fair, though, I was awfully conservative with the DDM analysis.

With that in mind, we’ll compare my valuation to that of what two professional analysis firms have come up with.

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 $168.00.

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 12-month target price (used in lieu of their fair value calculation) of $175.00.

I used the latter firm’s TP because their FV calculation was nonsensical. These values are all fairly close to one another, indicating a reasonable consensus. Averaging the three numbers out gives us a final valuation of $175.19, which would indicate the stock is 11% undervalued here.

Bottom line: International Business Machines Corp. (IBM) has more than 100 years under its belt, proving its adeptness at adapting and succeeding. While their turnaround is taking a bit longer than anticipated, the company has great fundamentals, growth in the right areas, and a commitment to paying its shareholders a big and growing dividend. With a yield near 4%, a long-term dividend growth rate well into the double digits, and the potential that shares are 11% undervalued, there’s a lot to like about this dividend growth stock right now.

— Jason Fieber

Note from DTA: How safe is IBM’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 91. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, IBM’s dividend appears very safe with an extremely unlikely risk of being cut. Learn more about Dividend Safety Scores here.

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