Everyone is down on IBM (NYSE:IBM). Revenues are falling, the product lineup is uninspired at best, and many think leadership needs to be changed. And by looking at just the stock price this year, I would agree. IBM is 25% off its March highs while the S&P 500 is up 10% from then. IBM is seen as a value company and is trading off its free cash flow. That's the only metric that has mattered since 2009. In the chart below you can see the last five years price has trailed the FCF of IBM.
IBM data by YCharts
This is telling how investors see IBM - a cash generating company with no exciting future growth. However, this view of IBM needs to change. IBM has filed for more patents than any other company for 21 years in a row. I think we could all agree that a lot of these patents will never pan out to be profitable, but IBM is getting into two game-changing industries in a big way.
The most exciting technology is graphene. This nanotechnology is made of pure carbon and can be made to be only one atom thick. This material is 100 times stronger than steel and conducts heat and electricity very efficiently.
In January 2011 IBM was the first company to show that an integrated circuit and transistor could be built with graphene. And IBM still is more advanced than anyone else with its wafer-scale graphene integrated circuits. This means that our electronics can get smaller, lighter and more powerful than what can be accomplished with silicon processors. This is just one example of what graphene can do.
Why else would IBM be interested in this technology? Putting the pieces together, IBM believes silicon has reached its maximum potential for processors and circuits. If that is true one of its main businesses, servers and cloud computing, will become commoditized and margins will get squeezed. Amazon (NASDAQ:AMZN) has already started the price war in cloud computing and have eroded margins for everyone in the industry. To distinguish themselves, IBM needs a new material for its servers. Graphene should make IBM's servers cheaper, lighter, faster and use less electricity.
IBM spent over $1 billion this past year on expanding its cloud operations because the company believes this is essential to serving its customers. IBM now has a data center on every continent (except Antarctica) and in every major financial center.
This is important not only for speed of its cloud services but for the sovereignty of the data. With government spying and hackers running rampant, governments around the world are creating laws to specify what data can or cannot be stored outside the country. With laws about data in constant flux many companies are deciding to error on the side of caution and want to have data originating from certain countries to stay in that country. For a large multinational company this may require they store data in many different countries which makes IBM's cloud service the only choice for them. This is the reason IBM's marketing can boast 49 of the Top 50 Fortune 500 companies use IBM Cloud.
These big companies are the cash cows for IBM Cloud, but IBM also is appealing to the little guy. Starting up a program which lets developers create their first couple apps for free has made IBM more accessible to up-and-coming companies. Using Bluemix, a service designed to help create and expand an apps capabilities, allows even the bootstrapping solo entrepreneur access to IBM's big data information as well as an ever expanding cloud system. IBM hopes these apps become popular so it can make money hosting these apps in its cloud servers. IBM sees the future in apps whether they are on your smartphone or computer's internet browser or if they are produced by a large Fortune 500 company or by a single person and it wants those apps run on IBM Cloud.
However, IBM faces many challenges as many tech giants vie for a piece of the cloud computing market. IBM's two biggest competitors in cloud computer are Amazon and Microsoft (NASDAQ:MSFT). These are not the only competitors but are the ones it competes with most. These companies pushed market prices lower in the past couple years in an effort to gain market share against each other. The lowest cost producer is Amazon, although some argue it's because Amazon isn't worried about profits and won't survive in this ancillary business. Whether or not that's true they still are pushing the prices lower. However, IBM and Micorosft are able to differentiate themselves by offering more than just computing, storage and basic software tools.
Amazon has tried to commoditize the cloud computing industry. Realizing this, IBM and Microsoft are differentiating themselves by offering some of their software applications with their cloud. This is especially important for Microsoft and their office suite as it is losing market share to Google docs which is cloud-based and considerably cheaper. IBM also offers their business consulting services and many open source apps for developers to be more productive in their efforts. And to further differentiate their cloud services they allow even the smallest of developers access to the incredible power of the Watson supercomputer. Watson is the only computer of its power in the world today and by allowing access to this IBM will take itself out of the commoditized portion of this industry into a specialized cloud provider. Look soon for many new apps which harness IBM's big data capabilities.
I believe the full value of IBM can't be garnered from conventional methods. Sure, right now it is trading off of free cash flow and is sporting a nice 2.9% dividend which has been growing about 15% a year. That alone may be enough for some people to invest in this value company, but IBM is heavily investing in the future. Much like Google (NASDAQ:GOOG) (NASDAQ:GOOGL), IBM is performing services to create the cash necessary for the research and development costs of their future products. IBM has many exciting projects which could bolster future profits such as more graphene enhanced products, artificial intelligence services (including helping diagnose medical patients with over a 90% accuracy rating, which surpasses most doctors accuracy), and fully automated and customizable learning plans for students of all ages.
I see many parallels between IBM and Google in how they run their businesses and how they have grandiose plans to change the future for every single person in the world. The one difference between these companies is how the market values them. Google is trading at a Price to Free Cash Flow Multiple more than two times greater than IBM.
IBM Price to Free Cash Flow (Annual) data by YCharts
Google also has a forward PEG ratio that is almost four times greater than IBM.
IBM PEG Ratio (Forward) data by YCharts
Granted, Google is still growing revenues, but the past two years IBM, through some financial engineering, has grown its EPS at a faster rate. However, I don't believe Google's future prospects are four times greater than IBM's. IBM is working on many technologies that will change the world and if it accomplishes these goals its profits will change right along with the world. If IBM got only half the valuation Google possesses on these metrics, its shares would have 50-100% upside potential. These technologies are still a few years off, but soon investors should start looking at IBM for the company's future plans instead of the old legacy company it is pegged as.
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.