IBM's Future Growth Will Be Fueled By The Cloud

| About: International Business (IBM)


IBM is struggling to break away from hardware, but its investments in the cloud and software should pay off.

IBM pledges to earn $20 in operating EPS by next year, which is an ambitious goal.

IBM's investments in higher-margin businesses and billions in share buybacks should get it to $20, which makes its current valuation very attractive.

IBM (NYSE:IBM) isn't performing well this year, and its underlying financial results aren't likely to inspire much confidence. IBM used to be a dominant player in technology hardware, but over the past several years, the industry has changed. Hardware is no longer the growth engine of the future, and IBM is being anchored down by poor performance in that area.

However, the stock has been punished for its sluggish growth, to the point where its forward valuation looks to be overly discounted. IBM still generates a lot of cash, and uses the bulk of that cash to reward shareholders with buybacks and dividends. And, it can still grow, thanks to its aggressive investments in software and services.

Here's why IBM looks very attractive at its current level.

IBM's road map for the future

IBM's total revenue is down 3% over the first six months of the year. Gross profit has declined 1.3% through the same period. This performance is certainly nothing to brag about, but IBM has a plan to restore growth going forward.

Management has set a target of generating $20 per share in core operating profits by 2015. That would represent approximately 23% earnings growth over the company's 2013 operating profits per share, which might seem unlikely given its current revenue declines.

What IBM is counting on is steadily shifting its focus from hardware to other higher-performing businesses. This is the right thing to do, since hardware is exactly what has dragged the company down. Revenue from IBM's systems and technology group fell 16% through the first half of the year.

IBM's software and services businesses, particularly in cloud-based offerings, will fuel the future. Software revenue is up over the first six months, and the company is making great progress in several initiatives. For example, its cloud revenue increased more than 50% last quarter. And its cloud-delivered-as-a-service revenue nearly doubled last quarter, to a $2.8 billion annual run rate. Business analytic revenue grew 7% last quarter, and mobile revenue more than doubled.

In addition to growing revenue from all these sources, IBM should be able to reach its profit forecast because of its aggressive share buybacks.

Share repurchases will further boost EPS

IBM has a well-established practice of using billions of dollars to repurchase its own shares, which helps keep EPS growth intact. The company stated in its 2013 annual report that it has spent $108 billion on share repurchases since 2000.

And since IBM trades for an attractive valuation, these share buybacks are even more valuable. IBM trades for 9 times forward earnings. As IBM keeps buying back its own stock, each remaining one will become much more valuable.

Plus, investors are also getting a solid 2.3% dividend, and the company generates enough cash to grow the dividend over time. Over the past five years, IBM has increased its payout by 15% compounded annually. This will help increase shareholder value even more going forward.

IBM is currently stuck in a muddle-through period, but it's making the hard choices that will provide future growth. Hardware is a bad business to be in right now, but IBM's doing what it needs to do, which is to expand into new areas that have a much better future.

IBM has pledged to earn $20 per share in operating EPS by the end of next year. Assuming its growth initiatives gain traction and it keeps buying back loads of its stock, it should have no trouble getting there.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.