IBM (NYSE:IBM) spun off 80.1% of its hardware-IT business called Kyndryl (NYSE:KD) on Nov. 4, 2021. After doing that, the company has gotten rid of a negative growth and loss-making business. Now it will have more free cash flow (FCF) to keep paying its huge dividend. As a result, IBM stock should do well over the next year.
That will be good news for shareholders in IBM stock, as it was down 5.3% year-to-date as of Friday, March 4 with a closing price of $126.62. One thing helping the stock has been its huge dividend of $6.56. That gives the stock a very dividend yield of 5.18%.
As a result, investors want to know if the company can keep on paying this huge dividend after the spin-off.
Where Things Stand With 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. This might make it appear that IBM can afford the dividend on a net income basis since it’s below the $2.46 billion in net income.
However, we need to look at it 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. There are also certain adjustments that need to be made since the company has a financing division.
Therefore, we are highly dependent on 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 for IBM Stock
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.
And now we know that the company can do this. Its annual free cash flow 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 4.82%, 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 4.82%, the price target will be $141.91. That represents a potential rise of 12% over the price on March 4 of $126.62.
Moreover, Morningstar reports that IBM’s average yield over the last 5 years has been 4.63%. Therefore, using the same methodology, the price target is $147.73. That represents a potential upside of 16.7% in the stock price.
This shows that IBM stock is likely to be a good investment for value investors over the next year.
On the date of publication, Mark Hake did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.