IBM:FUNDAMENTAL ANALYSIS|PRICE ACTION+NEXT TARGET|SHORT IDEA 🔔

International Business Machines continues to transform itself into more of a cloud computing company. Since it acquired Red Hat a couple of years ago, it has increasingly distinguished itself as a hybrid cloud leader. In addition, the spin-off of the managed infrastructure services business may allow IBM to focus solely on that growth.

Nevertheless, while IBM offers investors many reasons to buy, one key issue may scare off some investors in the near term.

The first advantage is the impending spin-off of Kyndryl.

Despite IBM's breakthroughs in chip manufacturing and supercomputing innovation, the company's fastest-growing segment is the cloud. CEO Arvind Krishna has been committed to turning IBM into a cloud player since he took the helm in April 2020. He was instrumental in Red Hat's acquisition, and Red Hat's Kubernetes and OpenShift software can simplify the communication problems inherent in public and private clouds working with each other.

Moreover, Kyndryl's spin-off from IBM should facilitate this transition, and IBM shareholders will receive a portion of Kyndryl's stock at the time of this spin-off. While this may seem like a convenient way to offload an inefficient business, Kyndryl is taking a $60 billion backlog with it. This volume of work allows Kyndryl to arrange a turnaround under a management team focused solely on the managed infrastructure business.

Krishna believes that once Kyndryl becomes a separate division, IBM will be able to consistently deliver mid-single-digit revenue growth, a significant improvement for a company that has sometimes failed to deliver positive revenue growth in the recent past.

A second advantage is dividends and cash flow.

IBM continues to generate cash flow despite its difficulties with earnings growth. Over the past 12 months, the company has generated about $9.7 billion in free cash flow, enough to easily cover $5.8 billion in dividend expenses over that period.

These dividends have long pleased investors. The company now pays shareholders $6.56 per share a year, which at current prices is about 4.7%. This is considerably higher than the 1.3% that the S&P 500 Index currently yields on average.

In addition, IBM has the status of a dividend aristocrat, as the company has increased its payout for 26 consecutive years. Investors should note that both IBM and Kyndryl will retain aristocrat status after the separation. However, the decision to retain aristocrat status will be made separately by the boards of IBM and Kyndryl.

The third benefit is an improved balance sheet.

IBM's cash flow is crucial for another reason. IBM's current debt is $55.2 billion, a huge burden when the company's equity is just over $21.9 billion. Nevertheless, while this debt remains a big burden on the balance sheet, shareholders should remember that the company has reduced debt by $6.4 billion in the past 12 months. It has also reduced those liabilities by $17.9 billion since the Red Hat acquisition in 2019.

That is significant because the Red Hat purchase cost IBM $34 billion. In the second quarter of 2019, the company increased its total debt by $23 billion in one quarter to cover the cost of the acquisition. So so far, the company has paid back all but $5 billion in debt from the Red Hat deal.

The only downside is the uncertainty about the Kyndryl division.

Unfortunately, questions remain about what each company's balance sheet will look like after the spin-off. For example, IBM has not said how it would distribute the remaining debt load between the two companies. That is important because an unfair split could jeopardize the balance sheet of at least one of the companies.

Among other things, the issues go far beyond the level of debt and the state of IBM's equity capital. Although the company has told shareholders that they will receive a portion of Kyndryl's stock, they have no clear idea of the number of shares they will receive. In addition, IBM has not disclosed how much of Kyndryl's revenue, net income, or free cash flow is generated and how this affects shareholders on a per-share basis. This uncertainty about the company's valuation comes at a time when IBM's P/E ratio has risen above 23, something not seen since 2018.

In addition, this uncertainty is particularly important to IBM's dividend-oriented investors. IBM has told shareholders that the two companies will split the payout. Thus, investors cannot accurately gauge each company's future earnings or their ability to keep the portion of the dividend they receive.

So should you consider IBM? Despite the unanswered questions, both companies should perform better as separate units. Since IBM is more of a cloud company, its massive growth in that niche should have a bigger impact on its stock. Moreover, Kyndryl probably has a better chance of turning a huge order book into growing revenue, since its only priority is managed infrastructure.

However, income-oriented investors face profound uncertainty because they don't know which part of the business will provide the most support for payouts. For this reason, investors in this class should consider staying on the sidelines until more information becomes available.