How IBM Makes Most Of Its Money Might Surprise You, and Excite You

Investors of a certain age may remember that International Business Machines (NYSE: IBM) — better known as IBM — was a powerhouse in its prime. That was back in the 80s and 90s, when mainframe computers and then personal computers first started to become common. IBM’s hardware was a centerpiece of the movement. The company even remained relatively relevant into the early 2000s.

Slowly but surely, however, competition chipped away at its dominance. Its sales ultimately peaked in 2012 because IBM didn’t do much to address then-nascent opportunities like cloud computing, mobile devices, and cybersecurity. It’s been so long since IBM has mattered that many investors have all but forgotten about it.

Well, IBM is back. It can’t be said that it’s better than ever. But it’s looking like a more promising investment than it has in a long, long time. This new IBM, though, is very different than the hardware-centric one that older investors might recall from yesteryear.

Meet the new-and-improved IBM

IBM has managed a consulting business for decades now, even if this work was entirely related to the use of its systems. And, for as long as its computers could be programmed, the company’s supplied some sort of software.

The importance of these different operations has been shaken up over the course of the past several years, however. Software has become IBM’s single biggest source of revenue as the company turns up the heat on hybrid cloud computing. Its consulting business is still sizable, but it’s a distant second now, with infrastructure (hardware) running a close third in terms of sales.

Data source: IBM. Chart by author. Figures are in millions.

This might be surprising to investors who remember what IBM used to be. But it shouldn’t be too surprising. This is a change the company’s known was coming — and even intended — for years now.

As CFO James Kavanaugh reminded investors last month at Morgan Stanley’s annual Technology, Media and Telecom Conference, for every dollar’s worth of systems that IBM sells, it generates an additional $3 to $5 worth of eventual software revenue and between $6 and $8 worth of services sales. One product or service doesn’t really work without the other. This is how the company’s top and bottom lines have remained so stable of late, even if the growth rates for both are modest.

That’s only half of the bullish picture for this particular business model, though. What’s not highlighted by these numbers is how this platform/software/services mix drives the greatest degree of revenue for the company’s highest-margin business. That’s software. Roughly 80% of IBM’s software sales are converted into gross profits, making it (by a country mile) the company’s top income driver.

Chart showing that half of IBM's gross profits are generated by sales of software.

Data source: IBM. Chart by author. Figures are in millions.

Surprised? Don’t be. Think about it. Hardware is manufacturing-intensive since each unit produced requires the purchase of several technological components. Consulting requires people. Software, however, is very different. Once the code is written, it can be readily copied and distributed at little to no cost.

For income investors, there’s very little not to like

This shift in the business model is a two-edged sword. While it sets the stage for consistent sales and earnings, it also limits potential growth rates. IBM sells systems at competitive, lower-margin prices in order to spur higher-margin service and software sales. The ensuing cloud-centric software and consulting revenue, though, is only booked on a quarterly basis from that point forward. It could take years for a customer to update their tech with the purchase of a new platform that prompts a new service or consulting contract, or renews the need for software to make the hardware work.

In many ways, though, this model simplifies the business into one that IBM can execute very well. The ultimate goal is simply bringing more clients into the fold. Once they’re onboard, they’ll likely remain onboard as paying customers for a while. Indeed, some of them will remain lifetime customers just because they’re already familiar with IBM’s offerings.

As for investors, IBM’s shift toward a services- and software-oriented business model bodes well for the company’s future cash flow, and for this tech stock’s future dividends. To this end, IBM is expecting free cash flow of $12 billion this year. That’s up from last year’s figure of $11.2 billion, which is up from only $9.3 billion a year earlier. You can plug into this cash cow while the stock’s dividend yield stands at 3.4%. By the way, this yield is based on a dividend that’s been raised every year for the past 28 years.

James Brumley has no position in any of the stocks mentioned. The Motley Fool recommends International Business Machines. The Motley Fool has a disclosure policy.

How IBM Makes Most Of Its Money Might Surprise You, and Excite You was originally published by The Motley Fool