IBM Can Afford to Raise Its Dividend Now That It Has Spun Off Loss Making Kyndryl

• IBM (IBM) stock is now up 13% since its trough price at the end of Nov., when it spun off loss-making Kyndryl (KD) as a separate public company.
• This takes a huge burden off of IBM and the company is now in a better position to both raise its dividends and buy back shares
• The company's latest financials show that it would have made $7.9 billion in free cash flow (FCF) last year without KD, giving it a huge 6.65% FCF yield.

International Business Machines (IBM) completed its “separation” as it likes to call it from its loss-making information technology systems division called Kyndryl Holdings (KD) on Nov. 3. Actually it still retains 19.9% of the company and the 80.1% remainder was spun-off to IBM shareholders in a tax-free dividend. Since then the company has been freed up to produce much higher free cash flow (FCF). 

This will allow IBM to continue raising its dividends and also buying back shares. As a result, IBM stock should do well over the next year. The company already has gone to great lengths in its latest financials to show how that will work out. 

That will be good news for shareholders in IBM stock, as it was down 1.7% year-to-date as of March 31 midday. 

One thing helping IBM stock has been its huge dividend of $6.56. That gives the stock a very dividend yield of 4.99%.

As a result, investors want to know if the company can keep on paying this huge dividend after the spin-off.

IBM’s Cash Flow

On Jan. 24, IBM reported that its surviving cloud and software business made a quarterly profit of $2.46 billion on a continuing basis vs. $1.19 billion last year. That represents a growth rate of 107%.

However, the dividend cost $1.474 billion for the quarter. IBM can afford the dividend on a net income basis since it’s below its $2.46 billion in net income.

However, we need to look at this situation from an FCF standpoint, especially now that Kyndryl is a separate company. The reason is that free cash flow takes into account actual cash payments in and out of the company, unlike net income which has lots of non-cash charges. There are also certain adjustments that need to be made since IBM has a financing division.

As a result, we need to use IBM’s own calculations of free cash flow. Fortunately, the company has gone to great pains to explain how its FCF is calculated. This helps us see how it will be able to cover the ongoing dividend payments.

The final section of the earnings report (page 12) shows how much FCF IBM made in 2021 “post-separation” from Kyndryl. The cash flow from operations was $12.8 billion for the year. After deducting $2.4 billion in capital expenditures and $3.9 billion from changes in financing receivables, its FCF was $6.5 billion.

However, given that there were one-time expenses of $1.4 billion related to the Kyndryl separation the company has a “baseline” FCF of $7.9 billion.

This is more than enough to cover the annual $5.869 billion in dividends for shareholders. It leaves over $2 billion that can be spent on buybacks, debt reduction, or dividend increases.

Consistent Dividend Increases

IBM has increased its dividend every year for the past 26 years. It has now paid out $1.64 for the past four quarters. That implies that the next dividend declaration should be higher if IBM is going to maintain this dividend growth history. This means that near the end of April IBM may announce a new dividend increase.

The good news is that we now know IBM can afford to do this. Its annual free cash flow, as shown in its financials without Kyndryl should be sufficient. Moreover, analysts expect that IBM will post significantly higher earnings this year than in 2021.

For example, Seeking Alpha’s survey of 16 analysts indicates that IBM will make $10.03 per share. That is significantly higher than the annual $5.21 in continuing operations earnings per share it made in 2021, as seen on page 5 of its earnings release.

That could also leave room for the company to begin buying back shares again, which would lower its dividend costs going forward.

What To Do With IBM Stock

The average dividend yield for IBM stock in the last four years has been 4.84%, according to Seeking Alpha. We can use this to estimate the value of IBM stock.

For example, let’s assume that IBM raises its quarterly dividend a little over 4% to $1.71, as it did a year ago. That puts the annual rate at $6.84.

If we divide 6.84 by the 4 year average of 4.84%, the price target will be $141.32. That represents a potential rise of 7.6% over the price on March 31 of $131.36.

Moreover, Morningstar reports that IBM’s average yield over the last 5 years has been 4.66%. Therefore, using the same methodology, the price target is $146.78. That represents a potential upside of 11.7% in the stock price.

This shows that IBM stock is likely to be a good investment for value investors over the next year.