Why IBM's Big Dividend Raise Is Right on the Money

By Markets Fool.com

It's been tough for International Business Machines shareholders to remain positive over the past few years. The company has suffered a prolonged malaise, marked by declining revenue and a falling stock price. In fact, IBM was the only Dow Jones Industrial Average component to lose ground in both 2013 and 2014. IBM was infamously late to the cloud party, and it's been weighed down by a significantly underperforming hardware business.

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To be fair, IBM is turning things around. It's investing aggressively in new businesses, which are slowly building into a meaningful part of the company. But it's hard to really notice the progress, because it's gone so slowly. After all, IBM is a huge company -- $168 billion by market capitalization -- which means a turnaround will take years, not months.

However, IBM has also made big strides in a key area to keep shareholders happy. Here's why IBM's 18% dividend increase means so much.

A turnaround is in place, but it will take time
It's easy to focus on IBM's headline numbers, which are far from impressive. Total revenue fell 5% in 2014, and the metric was flat in the first quarter, adjusted for currency and divestitures. Again, hardware was the problem. Systems and technology revenue fell 23% -- but excluding divested businesses and currency effects, it actually increased 30%.

That demonstrates the benefits of IBM divesting its low-margin hardware businesses. Last year, IBM sold its x86 server business to Lenovo for $2.1 billion, and it also sold its semiconductor business to privately held GlobalFoundries. In all, IBM rid itself of business operations that generated $7 billion in annual revenue but produced $500 million in pre-tax losses.

Going forward, IBM's turnaround will be driven by what management refers to as its "Strategic Imperatives," which include higher-growth areas like the cloud, analytics, and security.

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For example, cloud revenue soared more than 75% year over year last quarter, adjusted for currency and divestment. IBM's cloud-delivered-as-a-service business has now reached a $3.8 billion annual run rate, up from $2.3 billion in the same quarter last year. Business analytics revenue jumped 20% last quarter. Collectively, these growth categories grew revenue by more than 30%, adjusted for currency and divestments.

However, these initiatives will take time to materialize. IBM is a huge company with hundreds of thousands of employees and more than $90 billion of revenue last year, which means it simply can't turn on a dime. By returning more cash to its investors, IBM will at least help keep shareholder morale high.

Plenty of room for higher dividends
Even though IBM is struggling to grow revenue, it is still highly profitable and generates a lot of free cash flow. Total revenue fell 5% in 2014, but the company still generated more than $12 billion of free cash flow. For many years, IBM used the majority of its free cash to buy back a great deal of stock.

But IBM has also grown its dividend over time, and in recent periods, it has tapered off its share buybacks. IBM utilized $1.1 billion for buybacks in the first quarter, far less than the $8.1 billion spent on repurchases in the same quarter last year.

The savings can now be allocated toward higher dividends, since IBM has a very low payout ratio as it is. Excluding a change in its global financing receivables, IBM generated $2.6 billion of free cash flow last quarter. Its dividend cost the company just $1 billion, equating to a very modest 38% free cash flow payout ratio. The combination of a low payout ratio and much less money spent on share buybacks mean an 18% dividend increase is entirely appropriate.

IBM stock is down 15% in the past two years, badly under-performing the S&P 500 Index, which gained 32% in the same time. Raising the dividend is a great way to keep investors happy while the turnaround gains momentum.

The article Why IBM's Big Dividend Raise Is Right on the Money originally appeared on Fool.com.

Bob Ciura owns shares of Apple and International Business Machines. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple and International Business Machines. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.