IBM Transformation Continues, Expect The Shares To Trade To $250 By Year-End

| About: International Business (IBM)


Revenue is beginning to stabilize which should propel the shares higher over the next few quarters.

Management reaffirmed earnings of $18 per share which makes IBM unduly cheap.

Continued growth of its Software division will allow it to de-emphasize the hardware division.

Patience is one of the key traits an investor must possess. The market is full of pitfalls, leading to an investor prematurely selling out of what would be a winning position. The article below will discuss International Business Machines' (NYSE:IBM) revenue growth which has been absent over the past few quarters. At the end of the article, I will update my year end price target for the shares.

IBM has been besieged with falling revenue growth over the past eight quarters as the company looks to transition itself into a more software focused solutions enterprise. IBM's major emphasis is expanding its revenue generated from cloud applications while de-emphasizing the revenue generated from hardware. I would like to examine the hardware division dubbed Systems and Technology first. Sales for this division came in at $3.3 billion, a decline of 11% versus the same period last year. Clearly, this is IBM's weakest division with scant signs of improvement so far.

The software division, however, was able to grow revenues to $6.5 billion, a 1% increase from the prior year. The software division carries a much higher gross profit which greatly aids IBM in overcoming the weight of the declining sales from the hardware division on overall profitability. The Software division carries a pre-tax margin of 36.5%, which is certainly very attractive.

The largest division of IBM is the Services division. It came in with sales of $13.9 billion, which was down 1% from the previous quarter. The Services division has an estimated backlog of approximately $136 billion which is a truly staggering number. If we examine this for a moment, Services has a roughly 10-quarter backlog of contracts. The backlog offers quite a bit of visibility and predictability which I find very appealing. I believe the ease of predictability of IBM revenue and profits is what attracted Warren Buffett to the shares. The Service division carries a pre-tax margin north of 17%, an adequate number while not as attractive as the margins seen in software.

IBM is de-emphasizing its reliance on hardware and shifting its focus to higher margin service and software divisions. While revenue continues to shrink, as evidenced by the 2% decrease this quarter to $24.4 billion, the shift in business mix is leading to higher profits. IBM's gross profit rose to 49.1% versus 48.7% the comparable period before. Clearly, the emphasis on higher margin products is the correct course of action and the transformation is beginning to bear fruit.

IBM Chart

IBM data by YCharts

There are two things I will continue to focus on with regards to my holding of IBM. The first is the company's return of capital activities. IBM continues to repurchase a large amount of shares which will greatly enhance shareholder return once the transformation is complete. IBM is currently trading at less than 12 times its current year's recently reaffirmed earnings projection of $18 per share. The shares are unduly cheap, especially in light of the all-time highs the market is currently trading at. In my opinion, there is never a better time to repurchase shares than when your multiple is less than 15. IBM certainly didn't disappoint this quarter, reducing shares outstanding from 1.11 billion to 1.01 billion. As we can see from the chart below, IBM has steadily reduced shares outstanding over the past three years taking advantage of the lull in its share price.

IBM Shares Outstanding Chart

IBM Shares Outstanding data by YCharts

The second portion of IBM's capital allocation plan revolves around its return of capital to shareholders in the form of a dividend. IBM certainly hasn't disappointed in this regard. As we can see from the chart below, there have been steady dividend hikes along with the share repurchases. The shares currently yield a tad over 2% which is certainly appealing.

IBM Dividend Chart

IBM Dividend data by YCharts

The second part I continue to watch is the transformation of the company. I am particularly interested in the continued increase in IBM's gross margin. For the transformation to be successful, I would need to see revenues stabilize first, then eventually grow. I believe we are rapidly approaching stabilization in revenues as evidenced by the most recent earnings release. From here, the investing in higher margin divisions such as software, combined with the dramatic decrease in shares outstanding as evidenced by the chart above, will kick off a virtuous cycle of higher earnings which begets higher dividends along with a much higher share price.

I can easily envision a share price of $250 by the same time next year. I am actually being a tad conservative as IBM is projected to earn $20 per share next year, which doesn't exactly make my prediction wildly bullish. I continue to view IBM as the best value in the Dow 30 (NYSEARCA:DIA) and one of the lowest in the S&P 500 (NYSEARCA:SPY) as well. I am heartened by the recent earnings report and I remain long the shares. Thank you for reading and I look forward to your comments.

Disclosure: The author is long IBM. 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.

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