A Closer Look Suggests It’s Still The ‘Same Old’ IBM
Vincent Martin | Jul 19, 2022 16:23
- IBM has looked better lately as growth accelerates
- IBM’s hybrid cloud performance good, but not spectacular
- But rest of IBM is — once again — declining
IBM (NYSE:IBM) has been a cautionary tale for tech companies. It’s a warning, about what happens when companies get too bloated and too bureaucratic and fail to adapt to a changing competitive landscape.
IBM stock, too, has been a cautionary tale. It’s been a warning to investors about the risk of chasing high dividend yields and low price-to-earnings multiples.
But, recently, IBM has looked a lot better — on both fronts. IBM revenue increased 4% in 2021 (that figure excludes the former infrastructure business, Kyndryl (NYSE:KD), which was spun off in early November). Now, in 2022, growth has accelerated to 11% in the first quarter and then 16% in Q2. (Both figures are on a constant-currency basis.)
IBM stock has responded in kind. At Monday’s close, the longtime underperformer had crushed the market. With the NASDAQ 100 Index down 27% so far this year, IBM has rallied more than 3%. It has topped shares of many of the companies that supposedly were racing past it:
After Monday’s second-quarter earnings report, however, a closer look suggests that perhaps, not all that much has changed. IBM’s revenue growth is coming largely from one-time factors that are set to end. Valuation is not all that attractive. The dividend is at risk.
The lessons IBM has taught over the years still have value. And they still suggest that investors should avoid IBM stock.
h2 Hybrid Cloud Growth/h2The revenue growth seen in recent quarters is a big deal for IBM. This is a company that between 2013 and 2018 infamously went 22 consecutive quarters without posting year-over-year revenue growth. Declines began again in 2019 before IBM got back on the high side.
The constant-currency revenue growth being posted this year would suggest that those declines are in the past, and that IBM’s strategy is working. The acquisition of Red Hat, completed in 2019, was designed to make IBM a leader in “hybrid cloud” environments. Indeed, hybrid cloud revenue over the past four quarters has increased 16%, and 19% excluding currency effects.
But on both fronts, there are reasons for concern. IBM’s performance in hybrid cloud is solid — but probably not spectacular. The entire market is growing, at what one firm has estimated is a 21% annualized clip. (To be fair, it’s not clear how accurate that estimate is, but hybrid is no different than the entire cloud space, which continues to grow.) It’s good news that IBM hasn’t ceded market share, but it’s a little early to argue that the company is back to being a tech leader.
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That’s particularly true because the strength in hybrid cloud highlights relative weakness in the rest of the business.
h2 The Rest Of IBM/h2Over the past four quarters (again, excluding Kyndryl), hybrid cloud revenue of $21.7 billion has represented about 36% of IBM’s total sales. It has grown 16%, per IBM — or by about $3 billion.
The catch is that all of IBM, over the past four quarters, has grown revenue about $4 billion. Do that math: ex-hybrid cloud, IBM has grown sales by $1 billion, or less than 3%.
But even that overstates the case. Once Kyndryl was separated, IBM could book sales to that company as revenue. In each of Q1 and Q2 of this year, commentary from IBM suggests Kyndryl provided roughly $700 million in sales that didn’t exist the year before.
Adjust for that, and IBM’s business is — once again — declining. And that’s amid a pretty hot IT spending cycle that may normalize as startups shutter and larger enterprises rationalize costs (and workforces). In this context, IBM is basically a still-strong Red Hat business, and not a whole lot else.
h2 Is IBM Stock Cheap?/h2To be fair, even with the strong year-to-date performance, IBM stock still looks reasonably cheap. After Monday’s Q2 release, IBM modestly lowered its guidance for full-year free cash flow to $10 billion. But even at that level, IBM trades at about 12x this year’s FCF, and a slightly higher multiple to earnings (based on Wall Street expectations, which shouldn’t move much after a modest second quarter beat).
But, again, IBM stock has been in this valuation range for close to a decade now — and, for the most part, the stock has continued to decline. Shares are still down about one-third from highs reached all the way back in 2013.
Meanwhile, a low-growth company probably shouldn’t receive aggressive multiples to earnings or cash flow. And the issue here is not necessarily expectations for 2022 — but for 2023. The boost to reported revenue growth from Kyndryl will end, and the stronger U.S. dollar will add a drag to sales and profits.
All told, the argument for IBM since 2013 has been that the stock is a value trap, and that investors would do better paying a higher price for growth elsewhere in the space. After Q2, it’s difficult to see that argument as having changed all that much. At the very least, IBM still has a lot left to prove.
Disclaimer: As of this writing, Vince Martin has no positions in any securities mentioned.
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