IBM: Big Blue Preparing For The Next Chapter In Cloud

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About: International Business Machines Corporation (IBM)
by: Arturo Neto, CFA
Summary

Big blue has transformed itself from maker of computers to technology consultants - there's no reason why it can't transform into a major cloud competitor.

The stock has been beaten down by the market and now looks like a deep value play with lots of upside.

It might be one of the most attractive dividend payers in the technology sector with a 4.8% dividend yield and a potential price of $180.

A couple of months ago, I published an article called Microsoft (NASDAQ:MSFT) Might be the Best Technology Dividend Play. The stock is up 4% since then based on our thesis for potential dividend growth is not necessarily the current dividend yield. We are still waiting for a dividend boost sometime this quarter or next, but in the meantime, we found another tech company, and this one pays a hefty 4.9% dividend. Is it better? Perhaps we were too quick to name "the best technology dividend play." Or maybe there's room in our technology allocation for both.

Source: CloudTweaks.com

Major corporations around the globe are embarking on a journey of digital transformation by adopting sophisticated digital technologies like data analytics, artificial intelligence, unified communications, IoT, cyber security, and blockchain. In order to implement these emerging technologies effectively, it's essential to migrate enterprise IT workloads from on-premise hardware to cloud-based or Internet-based computer resources that can be made available to users on demand via the Internet.

This trend has made cloud computing an essential element of digital transformation because of the speed, computing power, cost efficiency and scalability offered by cloud platforms. Today, cloud customers are either migrating workloads to their own private cloud infrastructures or they are choosing to rely on a third-party or public cloud service provider. An increasing number of enterprises also have begun to adopt a hybrid cloud model which involves the use of both private as well as public cloud platforms to deliver agility and flexibility.

The global cloud computing market size is projected to grow at a CAGR of 18%, from $272 billion in 2018 to $623.3 billion by 2023. To benefit from changing paradigms, tech giants like Amazon (AMZN), Microsoft (MSFT) and Google (NASDAQ:GOOG) (GOOGL) have reorganized themselves to further emphasize their cloud businesses. These tech companies also are integrating AI and data analytics services into the cloud platforms that they are offering.

Like other technology companies, International Business Machine Corporation (IBM) has emerged as a leading cloud service provider and it too is focusing on emerging technologies like AI, analytics, IoT and blockchain. Best known historically for its servers and mainframes, IBM is now delivering the new generation of technologies by offering products like the IBM Cloud suite and the intelligent IBM Watson.

Reorganizing for Cloud

IBM’s decision to focus on the cloud and other high-growth businesses came when its legacy non-cloud business began to fade. The company’s investments in the cloud business are now their main drivers of revenue growth. As a cloud service provider, IBM offers cloud computing platforms, application development platforms, data management platforms, workload management services, migration services and optimization services. To cater to its customers’ evolving needs in a better way, IBM has organized its offerings into five business segments: Cloud and Cognitive Software, Global Business Services (GBS), Global Technology Services (GTS), Systems, and Global Financing.

Source: IBM 1Q2019 earnings presentation

The Cloud and Cognitive segment focuses on cloud platforms and AI products, the GBS segment offers application management and consulting services, the GTS segment delivers infrastructure management services, the Systems segment sells hardware and operating systems (OS) and the Global Financing segment provides IT financing solutions.

IBM’s strategic initiatives related to cloud technologies span across all these business segments, hence, the total revenue generated by each of these segments also includes the revenue generated by cloud-based products and services specific to the segment.

Focus on the hybrid multi-cloud market

Despite its focus on the cloud market, IBM’s cloud business is off to a slow start, lagging significantly behind those of all of its major cloud competitors. The company’s cloud business might be driving its earnings growth but it hasn’t proved to be strong enough to reverse the decline in the company’s year-over-year revenue.

Q1 2019 has turned out to be the third consecutive quarter of the company’s declining year-over-year revenue and the shortfall has clearly impacted investor sentiment.

IBM Revenue 2006-2019

Source: Macrotrends

However, IBM remains unfazed about its prolonged turnaround efforts as the company has set its eyes on the emerging hybrid multi-cloud market which is expected to throw open huge growth opportunities for the company. A hybrid multi-cloud environment is the next step in the evolution of cloud computing and more than 50% of enterprises have embraced a hybrid multi-cloud strategy for cloud deployments.

Source: RightScale

In a hybrid multi-cloud approach, an enterprise chooses to distribute its cloud-based resources across multiple cloud-hosting environments provided by different service providers. Besides reducing dependency on a single cloud vendor, a hybrid multi-cloud approach helps companies to take advantage of the best of what each cloud platform offers. Moreover, a multiple-cloud model provides more security, flexibility, cost-effectiveness, an increase in efficiency and an assurance to achieve full uptime potential.

It's estimated that the hybrid multi-cloud market will be worth US $1 trillion by 2020 and the migration of enterprise workloads to multi-cloud infrastructures will signal a new growth phase for the cloud market. IBM perceives the new phase as chapter two of digital transformation and it's bullish about emerging as a primary player in this burgeoning market. To achieve its goal, the company already has begun to take effective measures which include the acquisition of Red Hat (NYSE:RHT), a leading provider of open-source solutions. IBM’s $34 billion acquisition of Red Hat will be completed in the second half of 2019 and it's being viewed as a critical step to help IBM establish a strong foothold in the cloud market.

Red Hat Acquisition

A successful execution of a hybrid multi-cloud strategy requires enterprises to address the challenges that go with the strategy. One of the most significant challenges associated with hybrid multi-cloud deployments is achieving interoperability, portability and security compliance of applications across multiple cloud environments. The use of open-source cloud development platforms provides an effective way to overcome these challenges as well as manage workloads across multiple clouds. Hence, acquiring a pioneering open source company like Red Hat proves to be a most logical step for IBM because the acquisition gives its customers access to a plethora of tools for creating and deploying applications across multiple clouds on a larger scale. In addition, the acquisition also will accelerate IBM’s revenue growth and improve its gross margin and cash flow.

Source: IBM Investor Presentation 2018

It's important to note that IBM already is committed to open-source projects and the company allows combining its cloud services with open-source tools. However, it hasn’t managed to build sales and revenue momentum that Red Hat has enjoyed with open-source products. The Red Hat acquisition gives the company an even richer portfolio of open-source tools and services to help its clients achieve digital transformation.

Source: IBM Investor Presentation 2018

Among the popular Red Hat products, OpenShift will provide the greatest advantage to IBM because the tool allows developers to create, test and run applications in a multi-cloud environment. In addition, OpenShift is used by more than 1,000 enterprise customers around the globe and cloud providers like Microsoft, Amazon, Google and Alibaba (NYSE:BABA) utilize OpenShift in combination with their cloud platforms to enable hybrid cloud computing.

The Red Hat acquisition also will be a shot in the arm for IBM’s Watson AI platform which has failed to take a winning position in its race with cloud-based AI platforms delivered by Microsoft and Amazon. Even though it took the lead in branding its Watson AI product, IBM has lagged behind its competitors in driving the widespread adoption of the product in the cloud market. By accessing Red Hat’s open source solutions, IBM gets an opportunity to integrate Watson in a wider range of cloud-based applications.

The integration of IBM and Red Hat’s product lines will help to build cloud-based applications that can optimize end-to-end operations of a client’s business. The Red Hat acquisition is perceived as a game changer by IBM because it will not only position the company as a bigger open source and enterprise software player but also will enable it to find place in the upper echelon of cloud providers.

Laying a strong foundation

In anticipation of the multi-cloud future, IBM is investing heavily to build capabilities that will lay down a strong foundation to integrate with Red Hat products. In Q1 2019, IBM introduced new capabilities in its cloud suite by introducing IBM Cloud Integration Platform and Watson Anywhere solutions which will help accelerate hybrid cloud adoption.

IBM Cloud Infrastructure Platform is a development platform that accelerates cloud-based application development by allowing customers to securely access a range of development tools and services from any cloud vendor. Watson Anywhere makes Watson AI services available on all public, private as well as hybrid cloud platforms which also include AWS, Azure and Google Cloud.

This means that enterprises will be able to use Watson AI tools in applications that are hosted on rival cloud platforms that are popular. The addition of new capabilities to IBM’s existing cloud platform builds a strong groundwork for integrating the company’s cloud service offerings with value-adding Red Hat’s cloud technologies.

Divestment Strategy

In an attempt to reorient its business toward the evolving cloud market, IBM is not only including new capabilities in its product portfolio but also disposing off software units which have little scope of integrating with its core product offerings. More specifically, the company is divesting those products which are not expected to play a key role in the cloud future.

While divesting its products, IBM considers factors such as the attractiveness of the market, differentiation of the offerings, and the importance of the product line to the company’s value proposition. Divesting non-core product lines gives IBM an opportunity to continually reallocate capital and increase investment in emerging as well as high-value segments of the IT industry.

To sharpen focus on its strategic initiatives, IBM has divested its on-premise as well as cloud-based digital marketing and e-commerce product lines in Q2 2019. In April 2019, IBM sold its Watson Marketing and e-commerce product portfolio to Centerbridge Partners L.P. IBM’s marketing and commerce portfolio included solutions for marketing automation, personalization, customer analytics and payment gateway. The divestiture of the software units comes at a time when IBM is increasingly focusing on delivering fully-integrated cloud-based solutions that will optimize every business operation of the enterprise, including end-to-end supply chains. IBM’s marketing and commerce assets had little integration with IBM’s broader capabilities and they were being mostly sold as standalone products.

The IBM deal with Centerbridge is a second transaction that involves the selling of its marketing and commerce software units. Earlier, in Q4 2018, IBM had struck a $1.8 billion deal with HCL Technologies to divest its non-core marketing software units that include Unica, WebSphere Commerce and WebSphere Portal. As a part of the deal, IBM also is divesting other software units that focus on security (Appscan and BigFix) and collaboration (Domino, Notes and Connections). The divestiture marks IBM’s exit from marketing product lines and it gives the company an opportunity to focus on more value-adding solutions like Watson Supply Chain that can leverage on and integrate well with other IBM technologies like IoT, Blockchain and analytics.

Future Prospects

At the moment, it's difficult to judge IBM’s future prospects merely on the basis of its revenue performance due to several reasons. First, IBM is focusing on a multi-cloud future and the enterprise adoption of hybrid multi-cloud infrastructure has just begun to gain traction. Second, it's predicted that about 90% of enterprises will have adopted a multi-cloud strategy in 2020. Third, 80% of enterprise workloads which represent mission critical work are yet to move to the cloud. Most of the cloud opportunity lies in the future when a majority of enterprises will focus shifting mission critical workloads to the cloud to optimize every part of their business operations. This will be when real potential of IBM’s cloud business will be unlocked because there will be an increasing demand for tools and solutions that will help to manage workloads in a multi-cloud environment.

Being a key player in the IT industry for a long time, IBM has the necessary domain expertise related to different industries and sectors. IBM’s vertical-market expertise, its ability to innovate, and its long history of being a trustworthy partner turn out to be the company’s key differentiators. In addition, the company’s immense experience in handling mission-critical workloads coupled with its deep understanding of business workflows across diverse industries puts it in a strong position to help its clients manage the challenges associated with multi-cloud environments. IBM’s strengths and unique capabilities create a competitive advantage which will drive its financial performance in the future.

Source: IBM Investor Briefing 2018

IBM already has begun to reap the benefits of its expertise as the company is winning major technology contracts from large enterprises. In Q1 2019, IBM signed agreements with BNP Paribas and Santander Group to transition their IT infrastructures to hybrid, multi-cloud environments. The transitions also will help the two banks to tap into IBM’s cloud-based AI, analytics and blockchain offerings. Earlier in the quarter, IBM announced that it had entered into a $550 million agreement with Vodafone and a $325 million agreement with Juniper Networks to enable the enterprises leverage IBM’s expertise in building and managing multi-cloud environments. Previously, IBM has helped key clients like Lloyds, Allianz, Westpac, American Airlines and Anthem Insurance to migrate their critical workloads to IBM’s hybrid cloud.

Q1 2019 Financial Highlights

In Q1 2019, IBM reported revenue of $18.2 billion, an operating pre-tax income of $2.2 billion and operating earnings per share of $2.25. IBM’s cloud revenue growth has accelerated in Q12019 thereby leading to a year-over-year growth of 12% at constant currency to $19.5 billion. The company’s cloud as-a-service offerings had a year-over-year growth of 15% at constant currency and an annual exit run rate of $11.7 billion. In Q1 2019, IBM’s revenue generation and free cash flow has been positively impacted by the cloud and cognitive software segment as well as the GBS segment.

Source: IBM 10Q

In Q1 2019, IBM expanding both gross and pre-tax margins. The company’s operating gross margin increased by 90 basis points in the quarter. The increase was due to the strong performance of its GBS and GTS segments which together led to a gross margin increase of 160 basis points. The margin growth reflects the company’s shift to higher value services and its focus to improve productivity and operational efficiencies.

The company generated a free cash flow of $1.7 billion during the first quarter, which is $350 million more than the previous year. Over the last 12 months, IBM generated over $12 billion of free cash flow which is 114% of the company’s normalized GAAP net income.

For the rest of 2019, IBM aims to improve its profitability by prioritizing investments in emerging high-value segments and continuing to divest businesses that are not delivering value to its customers. In addition, IBM is continuing to plan and prepare for its impending acquisition of Red Hat. On the basis of its Q1 performance, IBM expects to deliver an annual EPS of $13.90 and a free cash flow of $12 billion.

My Take

IBM has underperformed the S&P 500 (SPY) by 10% over the last year. This performance differential is way overdone. The company has historically transformed itself when the market environment has shifted and there is no reason to doubt it can do it again. It went from providing hardware to providing consulting, and now it is shifting its focus to the cloud. Despite some investors considering a "cloudy" outlook, we see plenty of upside here. The stock is trading at a PE ratio of 9.6x and pays a dividend yield of 4.9%, and expected to grow. How would you like to be on the receiving end of this dividend streak?

Analysts have a price target of $148 on the stock but I think that's conservative. This is not a high-growth opportunity, however, this is a deep value play. EPS is expected to increase just 1%-2% in the next couple of years, partly because it's selling off non-core businesses while still trying to gain traction with cloud services.

My estimate of where it should be trading is closer to a PE of 13. With EPS estimates for 2019 at $13.91, that puts the stock at $180. For comparison, Amazon trades at a PE of 72x and Microsoft trades at a PE of 27x. Perhaps they should trade at a premium but the relative valuation gap seems to be too wide.

For dividend and income investors, a 4.9% dividend yield from a stable, soon to be aristocrat is a convenient way to wait for price appreciation. At a payout ratio of 47% and free cash flow that is twice the annual dividend, it's as safe a dividend as you're going to find and arguably one of the highest in the tech sector.

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.

Additional disclosure: This article is meant to identify an idea for further research and analysis and should not be taken as a recommendation to invest. It does not provide individualized advice or recommendations for any specific reader. Also note that we may not cover all relevant risks related to the ideas presented in this article. Readers should conduct their own due diligence and carefully consider their own investment objectives, risk tolerance, time horizon, tax situation, liquidity needs, and concentration levels, or contact their advisor to determine if any ideas presented here are appropriate for their unique circumstances. Furthermore, none of the ideas presented here are necessarily related to NFG Wealth Advisors or any portfolio managed by NFG.