What's The Value Of IBM's 'Strategic Imperatives' Segment?

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About: International Business Machines Corporation (IBM), Includes: ACN, AMZN, CRM, FTNT, MSFT, NTNX
by: Celeritas Investments
Summary

The reason IBM stock is mispriced.

IBM is shifting its resources to the "Strategic Imperatives" segment.

Declining revenue is pushing investors to neglect the growth side of IBM.

What is the intrinsic value of the "Strategic Imperatives" segment?

With a $147 billion market cap and price/revenue ratio of just 1.84, the lowest among tech giants, it seems investors are not buying IBM's (NYSE:IBM) story of growth transition. I don't see a reason for this - after all numbers talk.

IBM's third-quarter cloud revenue was $3.4 billion, higher than the $3.2 billion figure AWS recorded. However, analysts and investors are rewarding cloud sectors for companies like Amazon (NASDAQ:AMZN) and Microsoft (NASDAQ:MSFT) with high multiples while neglecting IBM's cloud, punishing it with utility-like multiples.

I believe that "IBM Facing Revenue Decline" headline is pushing investors to focus on the empty side of the glass while missing the valuable growth part of the company.

In this article, I will try to get an approximate valuation of IBM's "Strategic Imperatives" segment by valuing each segment as a standalone company. But first, I will give a quick justification for why the stock is mispriced by investors.

Why IBM stock is mispriced

All those following IBM know the main driver of its stock price fall - decreasing revenue. Although revenues managed to stabilize in the last four quarters, accompanied with the company shifting its focus into promising sectors, multiples (like low PE ratio) show investors are valuing IBM as a no-growth stock.

This shows investors' skepticism about the transition, postponing any move into the stock until the sky is clear. Personally, I believe in IBM's ability to transform itself. After all, we are talking about a tech company that was founded more than 100 years ago, and managed historically to follow tech frenzies effectively.

However, investing in a company facing transformation is a risky bet. Especially when the sector it is transforming into is facing intense competition from players with deep pockets. In case IBM failed in its growth strategy, its stock can be "extremely" damaged, since its valuation will be based entirely on revenue declining sectors.

But in case IBM succeeded in its mission, how should the market value the "growth" sector? Let's see.

Valuing IBM cloud

Since most companies don't disclose specific metrics regarding cloud operations, like net profit margins and in IBM's case operating margins, we can't precisely value the cloud segment. Thus, the most suitable way is to use the only available data - revenue.

To value the cloud business, take Nutanix (NASDAQ:NTNX) and Salesforce (NYSE:CRM) as comparables. Both companies are valued at an average of 7 times revenue. Apply this multiple on IBM's $12 billion trailing cloud revenue, and the cloud segment's value will be around $84 billion. That's 57% of IBM's current market cap.

This doesn't take into consideration IBM's moat, which is characterized by having the smartest machine ever built, Watson. Watson only works on IBM cloud. This will give the sector a competitive advantage by providing incentives for financial institutions especially to subscribe for the service.

That's because IBM is planning to provide Watson with the capability to help financial institutions in escalating regulations, risk management and searching for investment opportunities. And by the "Machine Learning" process, Watson is expected to increase its performance through time.

In addition, I believe that IBM's long -dated relations with big businesses will strengthen its position to steal market share from other cloud competitors.

Valuing Analytics, Mobile and Security

I will apply the same methodology to other "Strategic Imperatives" segments.

Analytics: This is IBM's biggest source of revenue in the "Strategic Imperatives" segment, having more than $15 billion in trailing revenue. IBM Analytics helps organizations uncover insights that improve business operations and suggests ideas that can boost performance. In this sector, the German company Accenture (NYSE:ACN) is considered a strong competitor, having $34 billion in annual revenue. Accenture has a price/sales ratio of 2.27. Apply this multiple on IBM's $15 billion trailing analytics revenue, and the segment's value will be around $34 billion.

Mobile and Security: Both segments contribute to only 21% of the "Strategic Imperatives" revenue. The segment generated only ~$5 billion in trailing revenue, but with an average increase of 15% yr/yr and an expected market of $170 billion for cybersecurity in 2020, the company is expecting huge increase in segment's revenue. Fortinet (NASDAQ:FTNT) is IBM's closest public competitor. Fortinet has a price/sales ratio of 4.49. Apply this multiple on the $5 billion revenue for IBM's M&S segments, and both will have a value of $22 billion.

Conclusion

Adding the parts, the "Strategic Imperatives" segment will be valued at $140 billion. That's close to 100% of IBM's current market cap. So the market is only valuing IBM based on this segment only, although "SI" contributes only to 40% of the company's total revenue. Thus, buying IBM stock at these levels will give you the other segments for free. Not to forget that these segments, like "Systems" for example, are still profitable with high profit margins (7.8% profit margin for the "Systems" segment). In addition, you will also get Watson for free since the metrics previously used don't take into account this competitive advantage in having the smartest machine ever built. I recommend buying IBM shares at these levels, but of course risks lies in management's ability not to monetize Watson as expected. And to be honest, I'm skeptical about Rommety's capability in running the company effectively. The company needs fresh blood, and I would be more than happy to see a management change in IBM.

Disclosure: I am/we are long IBM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.