- IBM has been gaining momentum recently after years of underperformance, with shares rebounding 18.9% in the past year.
- CEO Arvind Krishna has delivered a new vision for the company, focusing on hybrid cloud and AI business.
- IBM's strong Q2 results and focus on enterprise AI position it for future growth, with analysts projecting increasing EPS and an inexpensive valuation.
International Business Machines (NYSE:IBM) has been an unloved and underwhelming investment for more than a decade. At one point, IBM was one of Berkshire Hathaway's (BRK.B) only technology investments, but in 2018, Berkshire fully exited the position as it proved to be a 7-year investment mistake. Looking back over the past decade, IBM has declined -16.92% as shares had declined from the $180 level, but IBM has been gaining some momentum recently. Shares of IBM bottomed at around $91 during the pandemic crash and have ground higher as it shed the legacy business and focused on its future. Over the past five years, IBM is up 2.72%, and in the past year, shares have rebounded 18.9% as they are trading at the upper end of their 52-week trading range. IBM may not be the hottest tech company grabbing headlines, but they're starting to gain traction, and I think investors are realizing this isn't a dead money company any longer.
I believe IBM's transition will continue producing positive returns
Since IBM's former Cloud Chief succeeded Ginni Rometty as CEO in 2020, Arvind Krishna hasn't just talked a big game, he has delivered a new vision. Mr. Krishna was the driving force behind the RedHat acquisition, which served as the foundation of IBM's hybrid cloud and AI business. IBM completed the separation of its managed infrastructure services and continues to shed the stigma of being a legacy tech company. IBM is focused on its hybrid cloud and AI business and recently acquired Apptio Inc. from Vista Equity Partners to accelerate the advancement of IBM's IT automation capabilities and enable enterprise leaders to deliver enhanced business value.
In Q2 2023, IBM delivered strong results indicating its operations are alive and well. IBM's Q2 revenue came in at $15.48 billion, which was a slight miss of -$98.07 million, while its EPS of $2.18 beat the consensus estimates by $0.18. IBM has been innovating and expanding its strategic partnerships, which is being seen on its bottom line. IBM is working with Air Canada to improve its digital footprint and better utilize its commercial, operational, and financial data. With Diageo, IBM Consulting is working on a global digital transformation to improve customer satisfaction, optimize business workflows, and enhance its financial performance. IBM is also working with Nokia to implement RedHat's OpenShift platform to become its preferred platform provider on Nokia's core network applications business.
Many forget that IBM has been at the forefront of AI, and for investors who are willing to invest in an unpopular company such as IBM, this could be an advantage. According to a recent McKinsey study, AI has the potential to generate value equivalent to $2.6 trillion to $4.4 trillion in global corporate profits annually. We have only begun to scratch the surface with AI, and when you look at how embedded SaaS and cloud infrastructure is, there is a strong probability that companies will look to leverage AI in every aspect possible to increase efficiencies and profits. IBM has been focused on enterprise AI to solve business problems, and continues to infuse its software products with AI. IBM is tackling specific use cases such as digital labor with Watson Orchestrate, customer service with Watson Assistant, and co-generation with Watson Code Assistant. IBM has been making massive investments in the AI space and has over 20,000 data and AI consultants in addition to launching their Center of Excellence for generative AI, staffed with more than 1,000 consultants with specialized generative AI expertise.
IBM generated $5 billion in revenue from its consulting business in Q2, with around 45% coming from business transformation. IBM has seen increased client demand for digital transformations as its consulting business saw a 6% increase in revenue. IBM continues to position itself for the future, and is well ahead of many other companies. Arvind Krishna is delivering on a hybrid cloud and AI strategy and continues to position IBM as a top-tier option in these categories. As enterprise AI expands, IBM is positioned to reap the rewards of investing in higher-growth businesses with strong cash generation rather than continuing to support legacy infrastructure. It may take some time to play out, but over the next several years and even the next decade, IBM can continuously increase its EPS, and free cash flow, which should lead to more dividend increases and share appreciation for shareholders.
Analyst community sees IBM growing its EPS and IBM looks inexpensive.
IBM is projected to generate $9.57 of EPS in 2023, increasing to $10.08 in 2024 and $10.65 in 2025. There are 15 analysts making 2023 and 2024 projections and seven analysts looking out toward 2025. I am not looking past 2025 yet because there are only two analysts willing to look past 2025 at the moment. Based on these projections, IBM is trading at 15.49 2023's earnings, and 14.86x 2024 earnings. For a tech company, this looks inexpensive, and despite IBM's rebound in 2023, it's still inexpensive.
After comparing IBM to the following companies I still think there is room for IBM to continue higher:
- Verizon (VZ)
- Altria Group (MO)
- 3M Company (MMM)
- PayPal (PYPL)
- Philip Morris (PM)
- The Coca-Cola Company (KO)
- Meta Platforms (META)
- Procter & Gamble (PG)
- Alphabet (GOOGL)
- Apple (AAPL)
- Microsoft (MSFT)
- PepsiCo (PEP)
I use the price-to-FCF metric because FCF represents a company's cash after accounting for cash outflows to support operations. I like to use this metric rather than net income because FCF is a measure of profitability that excludes non-cash expenses and includes spending on equipment and assets. It's also a harder number to distort or manipulate due to how companies account for taxes, and other interest expenses. This also is the pool of capital companies utilize to pay back debt, reinvest in the business, pay dividends, buy back shares, and make acquisitions. I would like to see how much I am paying for a company's cash flow.
IBM is trading at 12.4x its TTM FCF. IBM is being discounted to the point where it's almost a tobacco company rather than a tech company that is highly involved in AI. IBM produces more FCF than KO, yet a beverage company trades at a 26.31x multiple on its FCF while IBM trades at 12.4x. This is a clear indication to me that the market continues to view IBM as a company of the old guard, which is an opportunity. IBM continues to generate large amounts of profits that can be used to reinvest in its business, and dividend increases.
IBM is currently trading at 15.49 in 2023's earnings, with 11.29% of EPS growth on the horizon in 2024 and 2025. Based on the EPS growth, IBM's forward PE gets down to the low teens based on 2025 earnings. This looks like a clear opportunity, especially if AI does become the next technological revolution, as IBM is positioning itself to benefit from the future deployment of capital from global enterprises. IBM hasn't been exciting, but it's not the same IBM, and based on its FCF and forward EPS, IBM looks inexpensive even after seeing shares appreciate over the past year.
IBM continues to grow its dividend and pay investors to wait
The dividend has been one of the only bright spots for IBM in recent years. Investors have been paid a hefty yield to stick with IBM over the years. IBM is currently paying $6.64 per share through its dividend, which is a 4.43% yield. IBM is working toward becoming a Dividend Aristocrat as its grown the dividend for 23 consecutive years. IBM has a payout ratio of 73.85%, and there is more than enough room for IBM to continue its dividend increases.
Since IBM started raising its dividend in Q2 of 2000, IBM has paid $77.58 in dividends to shareholders. Not many investors have owned IBM over the long haul, but this is a significant amount of income considering shares traded for $103.04 on 5/1/00. IBM has established a long track record of paying and increasing the dividend, and this trend can continue as there is significant room in the payout ratio, and EPS is projected to grow YoY. IBM continues to protect the dividend, and investors can generate a yield that will be larger than what risk-free assets are paying when the Fed starts to cut rates.
IBM is one of my favorite companies that is currently a Dog of the Dow. The digital transformation is real and taking form as IBM has divested its legacy businesses and is focused on where technology is headed, not where it was. IBM is approaching Dividend Aristocrat status with 23 years of consecutive dividend increases, and investors are getting paid over 4% while the company transforms its business. Based on IBM's results, how the company is positioned, the current price to FCF, and the forward P/E ratios, IBM looks very attractive. I think shares will continue to rebound, and IBM could break away from its stigma as a legacy tech company as AI becomes the next technological revolution.
This article was written by
Analyst’s Disclosure: I/we have a beneficial long position in the shares of AAPL, KO, PYPL, MMM, MO, VZ, META, GOOGL either through stock ownership, options, or other derivatives. 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.
Disclaimer: I am not an investment advisor or professional. This article is my own personal opinion and is not meant to be a recommendation of the purchase or sale of stock. The investments and strategies discussed within this article are solely my personal opinions and commentary on the subject. This article has been written for research and educational purposes only. Anything written in this article does not take into account the reader’s particular investment objectives, financial situation, needs, or personal circumstances and is not intended to be specific to you. Investors should conduct their own research before investing to see if the companies discussed in this article fit into their portfolio parameters. Just because something may be an enticing investment for myself or someone else, it may not be the correct investment for you.
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