Fundamentally, IBM (NYSE:IBM) is relatively cheap. This is all the more true if you take historical multiples into account. With shares, however, it is the same as with wines or a whiskey. What is cheap is not necessarily good. In fact, there are reasons why the market offers IBM at a hefty discount. But if you take a closer look, you can still see that IBM offers its investors some value. For long-term investors who are patient, IBM could therefore still be an interesting investment. So it's time to dig deeper into IBM's discount.
Fundamentally speaking, IBM is extremely undervalued. You can see that from the many multiples. If you look at the 3 or 5-year median P/E ratio, IBM could theoretically have an upside potential of more than 30 percent.
The price/book value ratio also indicates a significant undervaluation.
We can continue to play this game with all other multiples such as Price/FCF and historical dividend yields. But the problem is that this discount to the historical multiples has its reasons, which we will look at below.
The discount with which the market offers investors IBM has, of course, its reasons. Many investors simply did not like the disappointing development of the company, so they turned their backs on IBM.
This is very well illustrated by the development of revenue. Yes, there were a few quarters now and then where IBM was able to grow a little bit. But if you look at the development over a longer period of time, this does not spread much joy. So while the high-flyers of the tech and cloud scene posted enormous revenue gains, IBM on the other hand, shrank.
The picture becomes even sadder if you look at the last 10 years, the time of the bull market, which has built up extremely high levels of prosperity (but not for IBM investors obviously).
The next chart also illustrates this dilemma well. IBM has been on a plateau in terms of revenue for many years and has not really managed to reach a new level. If you take a closer look at the development of earnings, the actual picture is even worse than the chart below, because IBM has been able to extremely support earnings per share through massive share buybacks. Although these are tools from which investors can profit in the long term, it does not help if the operating business does not grow further. That IBM is already reaching its limits, you can also see from the ever-lower dividend increases. And now that share prices are particularly low, IBM does not even have the financial leeway to buy back more shares, as it has to pay off the debt for the Red Hat deal.
(Source: IBM; EPS, cash-flows, and dividends)
And the last quarter does not bring any real improvement either. With a drop in revenue of more than 3 percent, IBM once again closed a quarter in which it continued to shrink.
(Source: 1Q Results)
(Source: Market share cloud computing)
Investors have become impatient over the years and have lost interest in continuing to hope for the turnaround, which, despite the flowery promises (keyword: Watson) never came true.
And indeed, IBM is still in the process of rebuilding and had problems to find the right profile for a long time. That may have changed with the Red Hat acquisition. And this could be the value for investors who are patient and can wait.
A growing cake is a growing cake
Yes, IBM is lagging behind Amazon and Microsoft in the cloud computing market. But IBM will still profit extremely from the growing market. A growing cake is a growing cake. Thus, all areas of the cloud computing segment should grow in the future. Of course, IBM can also profit from this, if it approaches things in the right way.
Not all clouds are the same
And this brings us to a crucial point. The statements about individual market shares are in part misleading because the market is extremely segmented. There are, for example, many more players in the SaaS (software as a service) market than in the IaaS (Infrastructure as a service) and PaaS (platform as a service) markets. You also have to differentiate between private, public, and hybrid markets. In a hybrid cloud, for example, some data is stored on public servers, and critical data remains on private servers.
Through the Red Hat acquisition, IBM has positioned itself particularly in the hybrid cloud and is attempting to serve all service models (IaaS, PaaS, SaaS). The expected growth for this market segment is very good at 18 percent p.a.
(Source: Hybrid Cloud Market Growth Forecast)
For example, Red Hat sales grew by 24 percent in the 4th quarter of 2019. And in the first quarter, the Red Hat unit was also able to grow in line with the market at 18 percent (normalized revenue growth of 20 percent). Furthermore, according to the earnings call, "the number of Red Hat large deals was up about 50% over last year." In addition, IBM has the opportunity to better connect the cloud business with the global business and exploit synergies.
CEO Arvind Krishna has a vision
In this regard, the new CEO Arvind Krishna gives hope that the profile will be sharpened in the future:
(Source: CEO Arvind Krishna post on LinkedIn)
Arvind Krishna was responsible for the Red Hat acquisition and although this deal was quite expensive, I think Krishna had a plan here and will now implement it. In the recent earnings call, he also let us know how he intends to implement his vision:
IBM, together with Red Hat, have unique sources of competitive advantage we can leverage to win the architectural battle for cloud. There's our open source and security leadership, our deep expertise and trust, but also the fact that we give clients that unique ability to build mission critical applications once and run them anywhere. Together with Red Hat, we are establishing Linux, Containers and Kubernetes as the new standard. This is winning the architectural battle for hybrid cloud.
So we are not talking about dreams of the future like blockchain, quantum computers but about a market that is there and that will grow every year for a very long time. IBM has now given itself a profile in this market. There are also initial indications that IBM's customers appreciate this profile. Recently, operating and net margins have also risen again. The upward trend in the gross margin was also at least maintained.
(Source: IBM margin)
The last 5 to 10 years have been very disappointing for IBM investors. The company has strayed somewhat from its original path on its way into the future markets. The market has therefore rightly punished IBM with a strong discount.
However, sometimes even the cheap wine tastes good. IBM is now putting everything into the Hybrid Cloud. I think it is the right step to give itself a proper profile in the ever more segmented market for cloud computing and thus be able to better address the customer's needs. What makes me feel positive here is that we are already seeing the first positive effects of the Red Hat acquisition and do not have to rely on flowery promises. Long-term and patient investors could benefit from this shift.
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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.