It might seem silly to compare IBM (NYSE:IBM) with Coca-Cola (NYSE:KO). One is an aging tech company and the other sells sodas and other beverages. However, the two companies have similarities: They own aging core businesses, they’re trying to boost their growth with acquisitions, and they’re both considered reliable income stocks.
IBM and Coca-Cola were also both major holdings for Warren Buffett’s Berkshire Hathaway. Yet Berkshire sold all of its shares of IBM last year while retaining a stake of nearly $20 billion in Coca-Cola.
Does Berkshire’s decision indicate that Coca-Cola is a better stock than IBM for long-term income investors? Let’s compare the two as dividend investments to find out.
Comparing Big Blue and Coke’s dividends
IBM currently pays a forward dividend yield of 4.6%, and it’s raised its payout annually for over two decades. Coca-Cola pays a lower forward dividend yield of 3.5%, but it’s hiked that dividend annually for more than five decades.
Over the past 12 months, IBM spent 50% of its free cash flow (FCF) and 65% of its EPS on its dividend. During the same period, Coca-Cola spent over 100% of its FCF and EPS on its dividend — mainly due to the refranchising of its bottling operations. Coca-Cola’s payout ratios should eventually drop back below 100% after it finishes those refranchising moves, but its dividend currently looks less sustainable than IBM’s.
Free cash flow growth
Both Coca-Cola and IBM generate plenty of FCF, but Coca-Cola’s FCF levels notably improved over the past year as IBM’s FCF levels declined.
IBM expects to generate $12 billion in FCF this year, and Coca-Cola says it expects to generate “at least” $6 billion in FCF. However, both companies’ FCF growth could be throttled by their latest acquisitions.
IBM is spending $34 billion to acquire Red Hat (NYSE:RHT) to strengthen its higher-growth “strategic imperatives” businesses (cloud, mobile, analytics, security, and social), and Coca-Cola recently closed its $4.9 billion takeover of Costa Coffee.
These acquisitions reduce both companies’ reliance on their slower-growth legacy businesses. IBM is hamstrung by its legacy tech businesses, while demand for Coca-Cola’s carbonated sodas is waning amid health concerns and shifting consumer tastes.
That’s why IBM is acquiring a growing list of cloud businesses, and why Coca-Cola is expanding its portfolio with teas, juices, energy drinks, and bottled water. These inorganic growth strategies prioritize sales growth over earnings growth, so investors shouldn’t be surprised if both companies’ FCF levels dip slightly throughout 2019.
Growth forecasts and valuations
Wall Street expects IBM’s revenue to decline 2% this year and for its earnings to rise less than 1%. IBM believes that the acquisition of Red Hat, which is set to close in the second half of the year, will eventually boost its sales growth back to positive territory over the next five years.
Analysts expect Coca-Cola’s revenue and earnings to rise 9% and 1%, respectively, this year. On an organic basis, which excludes acquisition-related gains (most notably from Costa), Coke expects its sales to rise 4%.
Coca-Cola is growing at a faster rate than IBM, but its forward P/E of 20 is much higher than IBM’s forward P/E of 10. Comparing the P/E ratios of two companies in different industries is an apples-to-oranges matchup, but they tell us that investors are still willing to pay a higher premium for Coca-Cola than for IBM.
Why investors should follow Buffett’s lead
IBM won’t be rendered obsolete anytime soon, but it’s starved for growth and faces formidable rivals like Amazon.com and Microsoft in the cloud services space. Buying Red Hat is a step in the right direction, but it isn’t a magic bullet.
Coca-Cola is also struggling, but the headwinds aren’t as severe. Buying other beverage brands and altering its core soda brands with healthier versions could bolster its sales growth, while tighter cost controls and the completion of its refranchising efforts should pave the way toward healthier earnings growth.
I’m not in a hurry to buy either stock now. But if I had to pick one as an income play, I’d pick Coca-Cola over IBM, since its core business faces fewer challenges. IBM pays a higher dividend and trades at a lower multiple, but it’s burdened by its older businesses and faces tough competition from Amazon and Microsoft.
John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool’s board of directors. Leo Sun owns shares of Amazon. The Motley Fool owns shares of and recommends Amazon and Berkshire Hathaway (B shares). The Motley Fool owns shares of Microsoft. The Motley Fool is short shares of IBM. The Motley Fool has a disclosure policy.