Interactive Investor

Stockwatch: what’s next for this sleepy tech titan?

23rd April 2021 16:37

Edmond Jackson from interactive investor


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Its first-quarter results were pedestrian, but its future looks bright.

Is International Business Machines (NYSE:IBM) really improving its prospects, or is its stock just treading water?  

After giving a company fair time to bear out a semblance of value, it is best to review if a stock is relatively under-performing - lest its underlying fundamentals lack traction. 

I initially drew attention to IBM at $131.50 (£94.78) in January 2019. Its then-CEO had heralded 2018 as “a very important inflection year” with revenue, operating income and earnings per share (EPS) all up for the first time in a long while.

The $34 billion acquisition of Red Hat Inc underlined a shift towards software – operating systems, cloud, mobile and storage – and IBM’s head of cloud and cognitive software has subsequently become CEO.  

Seemingly an attractive risk/reward profile 

It appeared a significant modernisation versus the stock on a low double-digit price-to-earnings (PE) ratio and prospective yield over 5% - a contrast with US technology leaders on euphoric valuations.

If the bubble element in tech stocks suddenly popped, which would you rather be left holding? After I made the case serially for Microsoft (NASDAQ:MSFT)  and Amazon (NASDAQ:AMZN), it appeared prudent to at least consider diversity via IBM. 

Yet overall revenue growth remains sluggish to materialise, and despite a recent $14 billion cash pile supporting dividends the stock has remained relatively out of favour. Possibly some extent of this reflects bias towards ‘growth’ favourites generally, which could change, especially if interest rates have to rise. 

In January 2020 I re-iterated a ‘buy’ stance at $143, given a forward PE around 10x versus 19x for the IT sector generally. Amazon and Microsoft (also in cloud computing) traded on 84x and 31x respectively. With the Covid-19 sell-off that March, IBM dropped to near $110 (affirming limited downside risk) then recovered to $125, but it barely advanced with the vaccines’ rally last November.  

‘Return to go’ after two years, three months 

Early last February it was under $120 and just lately advanced to $143, easing to $141 partly in reaction yesterday to President Biden’s intent to nearly double US capital gains tax for the wealthy. Essentially this is ‘return to go’, to use Monopoly parlance, since January 2019. During that time the high PE comparators such as Amazon and Microsoft have advanced 67% and 53% respectively – whether you count that as justified or inviting a bigger fall is up to you. 

Microsoft has eased similarly as IBM in response to the US CGT proposals, Amazon a tad more. It will be interesting to see if this conflates with Covid-19 resurgent in several US states - to temper the stock market in due course. While high PE stocks are potentially more exposed, a ‘risk-off’ sentiment shift would affect most equities.     

First-quarter 2021 results are better than expected 

The numbers are nothing exciting, but unless IBM has deftly managed expectations it is ahead in this respect.  

Like-for-like group revenue has edged ahead 1% to $17.7 billion, within which cloud and cognitive software are up 4%, the systems side also by 4%, and global business services by 2%. Mind that adjusting for currency changes all such growth rates were easier, and group revenue was actually 2% down. 

Total cloud-related revenue growth was more impressive: up 21% to $6.5 billion and by 19% over the last 12 months, driven by increasing client adoption of IBM’s hybrid cloud platform.

Demand for Red Hat software jumped by 17%, helped by strong uptake of its enterprise platform. But it appears the transformation is only steady in terms of affecting numbers at the group level. 

Based on order book indications for the next 90 days, management projects a return to IBM's pre-pandemic growth rate during the current second quarter. Obviously, the likes of Amazon and Microsoft have benefited from the pandemic in terms of more remote working. Likewise, Microsoft customers upgrade their ‘Office’ software subscriptions and Windows 10 sales benefit from those of new PCs. Amazon has also enjoyed a boom in home shopping and media content streaming, alongside its cloud computing services. 

Bosses avoid quantifying full-year revenue hopes 

They refer somewhat cautiously to “revenue growth based on mid-2021 foreign exchange rates” – as if modest currency changes alone could compromise actual group-level growth.  

Market expectations are anyway meagre: sub 1% like-for-like growth in the second quarter to $18.3 billion, and a gain of just 0.6% to $74.1 billion for 2021 as a whole. 

The broad objective after the technology services side is divested this year, is to become a circa $60 billion annual revenue business and growing. 

At $141 a share the prospective yield entertains 6.5%, so IBM ought to be relatively well-supported versus classic high PE/low yield growth stocks, exposed to profit-taking.  

EPS from continuing operations has come in at $1.06 a share, better than expectations. Encouragingly, IBM’s overall gross margin has risen from 45.1% to 46.3% on first quarter 2020, in context of the annual results showing 2019 to 2020 showing a rise from 47.3% to 48.3%. 

Net cash from operations is up 9% to $4.9 billion and adjusted free cash flow by 57% to $2.2 billion; and on this score management is confident enough to project annual free cash flow of $11 billion to $12 billion.  

This is however adjusted for a $3 billion impact from restructuring initiated in the fourth quarter of 2020 plus transaction costs of divesting the technology services side – to be named ‘Kyndrel’. I concede to critics of buying into turnarounds how exceptional costs can drag on. 

International Business Machines Corp
comparative financial results

  Three months ended   Year ended  
  31-Mar 31-Mar 31-Dec 31-Dec
  2020 2021 2019 2020
Revenue ($ million)        
Cloud & cognitive software 5,238 5,437 22,891 23,376
Global business services 4,136 4,234 16,798 16,162
Global technology services 6,467 6,370 27,361 25,812
Systems 1,368 1,427 7,604 6,978
Global financing 299 240 1,400 1,123
Other 62 23 1,092 169
Total revenue 17,571 17,730 77,147 73,620
Gross profit $ million 7,922 8,204 36,488 35,575
margin %        
Cloud & cognitive software 75.4 76.0 77.1 77.5
Global business services 27.2 28.2 27.7 29.7
Global technology services 34.0 34.5 34.8 34.8
Systems 50.2 54.5 53.1 55.9
Global financing 40.7 31.9 35.6 37.7
Total gross profit margin (%) 45.1 46.3 47.3 48.3

Kyndrel business may end up as IBM’s largest customer  

There is irony – albeit nothing new in big company restructurings – how this legacy business might generate $19 billion in sales versus IBM’s potentially $59 billion remaining.

Effectively, it would be a situation of intra-group sales persisting where, I also concede, you want to see growth in customers at large. 

It does, however, streamline IBM for its Red Hat software business then to sit atop those in cloud services and systems. The change is likely taking up management time and causing staff distractions; hence once the group settles on fewer revenue streams in better growth areas, attention can focus on maximising their potential. The incentive structure for sales teams has already been better aligned to strategy. 

Gartner global research ascribes high ratings to IBM 

Looking beyond the overall mediocre first-quarter results, it is encouraging for the medium term how Gartner has credited IBM as a leader in 12 of its ‘magic quadrants’ criteria in the artificial intelligence sector. This recognises IBM’s advances in language processing, trust and automation. 

A decade-long partnership with the Cleveland Clinic, which has pioneered various medical breakthroughs, will enable it to draw on IBM’s various services to accelerate discovery. Management touts this as “an area of incredible promise” given it will install the first on-premises IBM Q System One in Ohio. 

They also claim IBM quantum computing – which aims to solve complex problems the world’s most powerful supercomputers cannot – has “potential to unlock billions of dollars of value for our clients by the end of the decade”. 

Group revenue and profit will, of course, be the true test. I probably under-estimated the timescale required to streamline and turn around a legacy IT giant, however its risk/reward profile is improving. I am concerned that the pricing of US stocks generally exposes them to nasty surprises, but on a company-specific view my stance remains: buy. 

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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