With Red Hat now under IBM’s (NYSE: IBM) empire, we believe IBM’s large investments in the hybrid cloud and AI-driven data services are highly synergistic growth accelerators.
IBM’s sluggish growth could finally turn around by 2021, when its acquisition of the Linux cloud enterprise leader Red Hat is fully reflected in its performance. IBM Red Hat is creating the first fully hybrid multi-cloud environment (private cloud + public cloud + on-premise platforms). The deal is also about the data. Largely overlooked by the market is the value potential of the enterprise data that Red Hat brings, combined with IBM’s AI data capabilities, to attract more enterprise workload to IBM Red Hat hybrid cloud solutions.
This major acquisition by IBM should be seen in the light of a rapidly growing $1.2 trillion hybrid cloud market. Hence, patient value investors who start accumulating shares now at $145 could benefit from a discount, which we value at 69 percent, before Red Hat starts adding to the top line in 2021.
Slowing sales of its strategic cloud growth initiative – down 3 percent in Q2 2019 on a YoY basis, compared to 15 percent growth in the first half of 2018 – provide a buying opportunity.
A rapidly growing cloud market
As its legacy businesses continue to contract, IBM is looking to its cloud business to lead the company on a new growth trajectory. Red Hat is growing revenues at a much faster rate than IBM (3-year revenue growth of (20% vs 1.5%), and operates at higher gross margins (85% vs 47%).
Furthermore, the acquisition of Red Hat generates clear synergies, which will help boost revenues. Red Hat is the leader in enterprise hybrid cloud solutions while IBM has the lead in enterprise big data and analytics. Eighty-four percent of enterprises have a multi-cloud strategy, and the majority are migrating to a hybrid cloud strategy. IBM plans to provide those hybrid customers with AI-driven data, models, and tools to manage data anywhere. IBM’s Watson AI can now be deployed on any public or private cloud, including those of leading competitors AWS (NASDAQ:AMZN), Microsoft Azure (NASDAQ:MSFT), and Google (NASDAQ:GOOGL).
The overlooked data play will be the catalyst for taking IBM stock out of its depressed slump. After trailing the S&P 500’s return of 6.8 percent by 1 percent over the past 15 years, IBM stock is up 30 percent year-to-date. Based on analyst estimates, the stock price of 145 appears to be fairly valued, but those estimates are undervaluing AI-driven data as an accelerator of IBM Red Hat cloud adoption, and demand for related hybrid cloud migration and AI consulting services.
With the Red Hat buy, IBM is taking a lead on its hybrid cloud and AI data accelerator initiatives.
IBM’s Cloud Lead with Red Hat
IBM’s own solutions add to Red Hat’s enterprise Linux and OpenShift platforms. IBM is migrating its software-as-a-service solutions to Red Hat’s hybrid cloud. Use of Red Hat Enterprise Linux grew 20 percent in 2017 to equal 32.7 percent of the worldwide server market, yet 80 percent of enterprise workloads have not yet migrated to the cloud. Red Hat is the leader and “default choice” in the hybrid cloud, a $1.2 trillion opportunity by 2020, according to IBM.
Big data is the big sleeper for IBM Red Hat, though largely ignored in the deal buzz.
IBM is a top five vendor in big data and analytics software, hardware and services in market forecasted to grow at a CAGR of 13.2% to $274.3 billion between 2018-2022.
IBM plans to turn data into gold for enterprises. Seamless data integration with its on-cloud and on-premise enterprise management systems and applications raises the value proposition for IBM Red Hat enterprise hybrid cloud users.
IBM Red Hat’s first big hybrid cloud customer is all about the data. The real intent behind the recent IBM and AT&T (NYSE:T) strategic alliance is to provide the bandwidth and computing power for enterprises to manipulate data with their new AI data tools running on a low latency, high bandwidth network. To deliver, AT&T is migrating its software apps to the IBM cloud, and will manage those apps and workloads on Red Hat’s open source enterprise, and AT&T networking on Red Hat’s multi-cloud solutions. Once again, this illustrates the value of IBM’s acquisition.
Revenue Growth Estimates
Last week, Goldman Sachs added IBM to its list of “beaten down” stocks it considers to be attractive value investments. We agree and show in our discounted cash flow analysis below that IBM’s Cloud potential is undervalued.
Since the Cloud segment is the growth segment of the business and a growing percent of revenues, we use Cloud growth to determine revenue growth.
Cloud Revenues – Our valuation assumes IBM Cloud revenues growing in line with Gartner cloud market forecasts from 2018–2022. Gartner’s forecast is for the public cloud industry to grow 17 percent in 2018 and 2019, and then 16 percent in 2020 and 15 percent in 2021. (For simplicity, we do not separately break our IBM’s ~$1.3B private cloud business).
Other Revenues – Other Revenues, 2018-2019, are derived from Total Revenues based on the IBM Annual Report 2018 and Q1 2019 report, and HedgeMix from 2020–2023. From 2021–2023, driven by demand for enterprise hybrid cloud and integrated AI data solutions, we up the growth forecast by a conservative 1 percent a year. Our position is that IBM’s strong AI data value proposition will help drive more workload to the Red Hat hybrid cloud.
In 2022, Other Revenues are forecasted to turn positive as demand picks up for related hybrid cloud and AI services from IBM’s Global Technology Services (Digital Strategy, Cloud and Cognitive Process Transformation) and Global Business Services (Hybrid Cloud) units.
IBM Revenue Growth 2018–2023
Cloud % of Revenues
Source: Annual and Quarterly Reports of IBM and Gartner market estimates. Generated by HedgeMix Limited.
* 2020 cloud revenues grow 16% to $30.4B in 2021. When the $4B estimated Red Hat revenue is added the cloud revenues of 2020 equals $34.6B
Based on the fact that Red Hat revenues grew 15% annualized in H1 2019, we assume continued growth of 10% until the acquisition in 2021. This would add $4B to the IBM revenue at the time of the acquisition.
5-Year EBITDA DCF Analysis
Revenue: Produced using Gartner industry growth forecasts
EBITDA as % of revenue: FY2018 estimate kept constant.
CapEx: 5.2% of revenue (5-year historical average)
Working Capital: 9.3% of revenue (5-year historical average)
D&A: 5.3% of revenue (5-year historical average)
Terminal Value: 9.3x (Company LTM EBITDA Multiple)
Discount rate: 9%
Source: IBM Annual Reports and Gartner forecasts. Generated by HedgeMix Limited & FinBox
In the DCF model we use the revenues generated from table 1. To get EBITDA, we use the FY2018 actual profit margin of 21%. Please note that this estimate is below the median analyst estimates aggregated by Standard & Poors for EBITDA as a share of revenue. To make the model complete we use historical averages of key components (Capex, NWC Investment and D&A).
Source: IBM Annual Reports and Gartner forecasts. Generated by HedgeMix Limited & FinBox
Using the forementioned parameters the model generates a mid-level fair value of $176.59 for IBM. We support this valuation. Considering the growth rate of the international cloud market and the clear synergies from the recent acquisition of Red Hat, we believe IBM is undervalued with an intermediate-term upside of around 23%.
To complete the acquisition, IBM has taken on a high debt load. The company has stated that it will suspend stock purchases in 2020 and 2021 to pay down the debt. Once Red Hat’s debt and cash flows are added in 2021, IBM Red Hat’s debt/EBITDA will fall to 3x when the transaction closes and share repurchases are suspended, says Moody’s. It is currently 4.3x. The suspension of buybacks ensures cash to pay dividends, a decline in which would surely trigger the wrath of investors.
Meanwhile, IBM has minimized downgrade risk. S&P and Fitch have lowered their credit ratings one notch to A while Moody’s has downgraded its senior unsecured and long-term ratings from an A1 to A2. However, if IBM fails to grow revenues and deleverage, the risk of a further downgrade exists.
IBM may fail the test of the safe value stock Warren Buffet likes to cozy up to – it falls short of the earnings predictability criteria, having missed earnings in 13 of the last 20 quarters. Nonetheless, IBM Red Hat’s hybrid cloud driven by AI-infused data on the blockchain is a growth opportunity. During this forecast period to 2023, Cloud could grow to become 44 percent of revenues. Value investors should consider accumulating the IBM stock in 2019 and 2020, while the new cloud and data growth opportunity is not fully reflected in the stock price.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.