International Business Machines (IBM) is in the news recently since James Whitehurst, the current President of IBM and former CEO of RedHat is leaving the company. The stock dropped about (-5%) in response to the announcement. I last examined IBM’s dividend safety in August 2020. Since then, much has changed for IBM including traction for hybrid cloud, and the impending spinoff of Kyndryl, the Managed Infrastructure Services business unit. I am generally optimistic about IBM and even included the company as one of my Top 3 Dividend Growth Stocks for 2021. IBM started as one of the Dogs of the Dow in 2021 with a dividend yield over 5%. However, declining revenue and the spinoff will impact dividend safety. Hence, it is a good time to take a look again at IBM’s dividend safety.

Overview of IBM

IBM traces its history back to 1911 when it was founded. Today, IBM is a global information technology company that provides integrated enterprise solutions for software, hardware and services. IBM’s focus is running mission-critical systems for large, multi-national customers and governments. IBM typically provides end-to-end solutions. In the services business, IBM is the world’s largest IT provider with 5.5% market share. In software, IBM’s software business is mostly middleware, which is the software layer that connects applications and devices to each other. In hardware, IBM sells the z15 mainframes, storage, and the Power-based servers. 

The company has five business segments: Cloud & Cognitive Software (32% of total revenue), Global Business Services (22% of total revenue), Global Technology Services (35% of total revenue), Systems (9.5% of total revenue), and Global Financing (1.5% of total revenue). IBM generated annual revenue of about $73,621 million in 2020 and $73,779 million in the LTM.

Since the new CEO took over, IBM has refocused its business on a hybrid cloud and AI strategy. The IT giant has leveraged its acquisition of RedHat to transform its business. IBM is divesting the Managed Infrastructure Services business with about $19 billion in revenue. The spinoff of Kyndryl should be complete by end of 2021.

Source: IBM Q1 2021 Presentation

IBM Dividend and Growth

IBM is a long-time dividend payer and also a dividend growth stock. The company is one of the few that has paid a dividend consistently for 100+ years. IBM started this streak in 1916. IBM is also a Dividend Aristocrat with 26 years of consecutive annual dividend growth. 

IBM’s dividend yield has consistently been about 4.5% or more for about three years. IBM’s current dividend yield of roughly 4.7% is elevated compared to that of the S&P 500, which his yield of about 1.3% at the moment. Despite some COVID-19 pandemic related pressures on revenue and the long-term decline in the top line, IBM has not cut or suspended the dividend. This is a testament historical dividend safety and the company’s commitment on paying a dividend. Granted, IBM’s dividend safety has weakened due to long-term revenue declines and rising debt, more on that below.

The chart below from  StockRover* shows the dividend and growth rate since 2007 superimposed over the stock price chart (in gray). The growth in the regular cash dividend has been approximately 8.1% in the past decade, 3.2% in the trailing 5-years, and 1.5% in the past 3-years. Dividend growth has been slowing as revenue has declined and the payout ratio has risen.

Source: StockRover*

The forward dividend is currently $6.56 per share giving a forward dividend yield of about 4.7%. The dividend yield history for IBM is seen in the chart below. The average 5-year dividend yield is about 4.45%. The current dividend yield is higher than the trailing 5-year average. This suggests that IBM is undervalued base on dividend yield. The chart below indicates that the dividend yield has been roughly 4.5% or more since mid-2018 with a few periodic dips below that level. IBM is paying a dividend yield that an investor mostly finds in utility stocks and REITs making the stock very attractive.

Source: Portfolio Insight

IBM’s Dividend Safety

I like to take a look at three dividend safety metrics: earnings, cash flow, and debt. It is important to me as a dividend growth investor for all three to meet my criteria. Granted, there can be short-term fluctuations that results in a stock not meeting my criteria. But those are usually transient and not long term. Let’s do a deep dive into IBM’s dividend safety.

Earnings Perspective

IBM’s dividend is covered by adjusted diluted earnings in most years but 2020 was not a typical year. In 2020, IBM earned $8.67 per share but earnings were impacted by pre-tax charges. The company paid a dividend of $6.51 per share giving a payout ratio of about 75%. This value is high and above my threshold of 65%. The COVID-19 pandemic also affected revenue and earnings in 2020. But 2019 was a more typical year. IBM’s diluted adjusted earnings per share was $12.81. The company paid a dividend of $6.43 per share giving a payout ratio of 50%, an excellent value. In 2021, IBM’s consensus earnings per share is $10.93 in 2021. The dividend is $6.56 per share giving a payout ratio of 60%. This is below my criterion value.

That said, dividend coverage is worse after accounting for unusual items, but these vary year-to-year. IBM typically takes charges for mergers and restructuring and often has gains on sales of investments and assets.  For example, in 2020, diluted GAAP earnings per share was $6.13 per share. This means that the dividend was not covered by earnings in 2020. However, the dividend has been covered by diluted earnings in most years in the past decade with the exception of 2017 and 2020, as seen in the chart below from TIKR*.

Source: TIKR.com

Cash Flow Perspective

The dividend is significantly better covered by free cash flow. On a trailing basis, operating cash flow was $18,197 million in 2020 based on data from TIKR*. Capital expenditures were $2,618 million giving free cash flow of $15,579 million. The dividend required $5,797 million in 2020 giving a dividend-to-FCF ratio of about 37%. This is well below my requirement of 70%.

On a forward basis, the dividend requires about $5,864 million ($6.56 x 894 million shares). Assuming a similar FCF in 2021 as an estimate, the dividend-to-FCF ratio is about 38%, which is still a very conservative value. 

The cash flow required to pay the dividend increased from $3,473 million in 2011 to $5,797 million in 2020 and about $5,864 million in 2021. The growth rate has slowed as IBM has stopped issuing shares in 2015 and the dividend per share growth rate has slowed. It is unlikely that IBM will increase the dividend per share by more than low-to-mid single-digit percentages over the next few years. Instead, IBM is focused on reducing its debt and seemingly bolt-on acquisitions to reinforce its hybrid cloud and AI strategy.

Debt Perspective

One challenge for IBM is its debt. IBM divides total debt into core debt and global financing debt. IBM’s total debt has risen in the past decade and most recently spiked for the RedHat acquisition. Since then, total debt has declined to about $61.1 billion at end of 2020. Total debt has declined even further since Q1 2021 to $56.4 billion.

Source: Portfolio Insight

Global financing debt is debt that IBM uses to finance sales to customers and also for OEM commercial financing to suppliers, distributors, and resellers of IBM products. Global finance debt is about $18.3 billion at end of Q1 2021. 

This dollar amount is decreasing each year as IBM started winding down OEM commercial financing in 2019. This has the benefit of reducing total debt needs and reducing risk of financing non-investment grade customers (~39% of total). That being said, very little of this debt is past due of 90 days or more and the default rate is very low. IBM has seemingly been prudent in managing this type of debt.

Source: IBM 2020 Annual Report

Core debt is operational debt for running the company and acquisitions. Core debt rose for the RedHat acquisition but since then IBM has aggressively deleveraged and paid down approximately $16.6 billion in debt. Core debt is now about $38.3 billion offset by $11.1 billion in cash, equivalents, and marketable securities at the end of Q1 2021.

On a total debt basis, IBM’s leverage ratio reached 4.65X at the end of Q1 2020 at the time of the RedHat acquisition. This has come down to about 3.04X at end of 2020 and 2.8X in the LTM. If we look only at core debt, the leverage ratio is 1.7X in the LTM. I expect the leverage ratio to come further down as the company continues to pay debt according to its maturity cycle and not add new debt. Similarly, interest coverage went as low as 2.81X by end of Q1 2020. This has come risen to about 6.7X at end of 2020 and 7.3X in the LTM.

IBM has a solid credit rating as well. Standard & Poor’s gives IBM an A rating for its senior long-term debt. Moody’s gives IBM an A2 rating for its senior long-term debt. Both ratings are investment grade at the upper medium grade. This means that IBM has a strong capacity to meet financial commitments.

Source: IBM 2020 Annual Report

Our deep dive into IBM’s dividend safety shows that dividend safety has declined some over the past decade. That is not surprising as IBM has had difficulty generating top line growth and used debt to buy RedHat and revenue growth. However, the metrics indicate that the dividend is not at risk at the moment. Furthermore, IBM’s current management is deleveraging and is reducing total debt and increasing liquidity. This should improve interest coverage and reduce the leverage ratio over time.

Final Thoughts on IBM Dividend Safety Analysis

IBM is a stock that many people love to hate because of the declining top line and rising debt under prior management. The acquisition of RedHat has seemingly made IBM a player in hybrid cloud. Next, the spinoff of Managed Infrastructure Services will refocus IBM on software instead of services. Dividend safety was declining due to weakening earnings and rising debt. But IBM at its core is very profitable and debt is declining. The future IBM will likely have revenue and earnings growth albeit off a lower revenue base. IBM’s dividend is safe at the moment, and management has made statements in strong support of the dividend. I do not believe that IBM’s Dividend Aristocrat status is currently at risk.