A $34 billion acquisition will swell this stock’s debt, but it will also make it a leader in software for cloud-computing systems.
The deal is part of the company’s transition from traditional computer sales to faster-growing fields. In addition to increasing its business in cloud computing, the company is also developing analytics software to process big data. It continues to increase its revenue and earnings, although it missed the consensus estimate in the last quarter. Even with the high cost of its latest acquisition, this stock should keep increasing its dividend, as it has for each of the past 23 years.
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INTERNATIONAL BUSINESS MACHINES CORP. (New York symbol IBM; www.ibm.com) is one of the world’s largest computer companies, with operations in over 175 countries.
Due to slowing demand for its traditional mainframe computers and related services, IBM is aggressively shifting into faster-growing fields. They include cloud computing services (the storage of files and programs using the Internet) and analytics software (including its Watson supercomputer) to process increasingly large amounts of data.
The transition is paying off with rising revenue and profits—and dividends.
In October 2018, the company agreed to acquire Red Hat Inc. That firm is a leading developer of software for cloud-based computing systems, which let users access files and programs stored on remote servers over the Internet. Red Hat’s programs use the open-source Linux operating system. That lets it adapt its software to work on a wide variety of computer hardware and cloud systems.
IBM will pay $190.00 a share in cash for Red Hat. That a 62% premium over the share price before the offer. If you include Red Hat’s debt, the total purchase price is $34 billion. This is the biggest acquisition in IBM’s history. To put that amount in perspective, IBM’s market cap (the total value of all outstanding shares) is $97.7 billion.
The company held cash and investments of $14.5 billion (as of September 30, 2018), so it will have to borrow most of the funds it needs to finance the Red Hat purchase. That will increase its long-term debt, which now stands at $36.0 billion, or 37% of its market cap.
IBM expects the new operations will add $3.2 billion to its annual revenue of $80.4 billion. Red Hat will continue to operate as a separate business, so there’s little opportunity to cut jobs and other costs. Even so, Red Hat should generate $1 billion of free cash flow (regular cash flow less capital expenditures) in its first year.
Assuming Red Hat shareholders and competition regulators approve, IBM expects to complete the acquisition by the end of 2019. Red Hat’s shares are trading well below IBM’s offer, which indicates that investors do not expect a higher bid. If Red Hat backs out of the deal, it will have to pay a $975 million break fee to IBM.
Big acquisitions like this entail considerable risk, which is why IBM’s shares fell immediately after the deal. As well, the company will suspend share buybacks in 2020 and 2021. That will free up cash, which it can use to pay down debt.
However, the purchase will make IBM the largest provider of software for hybrid cloud systems. They combine company-owned servers with public cloud services (such as Amazon Web Services and Microsoft’s Azure). Moreover, IBM has worked closely with Red Hat in the past. That familiarity cut the risk of this purchase.
Blue Chip Stocks: Company has paid dividends continuously since 1916
The company reported better-than-expected earnings for the third quarter of 2018. However, its revenue missed expectations.
In the three months ended September 30, 2018, IBM’s overall earnings rose 2.9%, to $3.13 billion from $3.26 billion a year earlier. Due to fewer shares outstanding, per-share profits gained 4.9%, to $3.42 from $3.26.
Those figures exclude unusual items such as costs related to recent acquisitions, changes to IBM’s employee pension plans and items related to the new U.S. tax code. On that basis, the latest earnings beat the consensus estimate of $3.40 a share.
However, IBM’s revenue in the quarter dipped 2.1%, to $18.8 billion from $19.2 billion a year earlier. That missed the consensus estimate of $19.1 billion. If you factor out exchange rates, revenue was unchanged.
The revenue decline was mainly due to a 5.7% drop in revenue for the company’s Cognitive Solutions business, which includes IBM’s Watson supercomputer and artificial intelligence software. That decline offset higher revenue from cloud, security and consulting operations.
Excluding currency rates, revenue from Strategic Imperatives (IBM’s cloud, analytics and other new businesses) over the past 12 months was $39.5 billion. That’s up 13% from the same period a year earlier. The company expects annual revenue from those operations will total $40.0 billion by the end of 2018.
IBM still expects to earn at least $13.80 per share in 2018. The stock trades at just 9.0 times that forecast. It’s a particularly attractive multiple, as the company continues to spend around 7% of its revenue on research. Those outlays depress current earnings, and boost IBM’s p/e.
The company has paid dividends continuously since 1916 and has raised the annual rate each year for the past 23 years. Starting with the June 2018 payment, IBM raised its quarterly dividend by 4.7%, to $1.57 a share from $1.50. The new annual rate of $6.28 yields a high 5.5%. In the past five years, IBM’s dividend has grown at an average annual rate of 10.6%.
IBM still expects to earn at least $13.90 per share in 2018. The stock trades at just 8.1 times that forecast. It’s a particularly attractive multiple, as the company continues to spend around 7% of its revenue on research. Those outlays depress current earnings, and boost IBM’s p/e.
Recommendation in Wall Street Stock Forecaster: IBM is a buy.
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