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Is International Business Machines (IBM) a Buy?

By Leo Sun - Updated Apr 13, 2019 at 12:28PM

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Big Blue looks like an undervalued dividend stock, but it's cheap for a reason.

IBM's (IBM 1.21%) stock rallied more than 20% this year, as a better-than-expected fourth-quarter report in January and optimism about its acquisition of Red Hat (RHT) brought back value-seeking investors. IBM still looks cheap at 10 times forward earnings and it pays a high forward dividend yield of 4.6%.

Do the low P/E ratio and high yield make IBM a compelling buy? Or should IBM -- which remains down about 25% over the past five years -- stay in the penalty box until it shows more signs of improvement?

A man holds papers and looks at computer screen displaying charts and tables.

Image source: Getty Images.

What went wrong with IBM?

Under CEO Sam Palmisano, who led IBM between 2002 and 2011, IBM focused heavily on divesting businesses, cutting costs, and buying back shares to boost its earnings. As a result, IBM fell behind the tech curve in multiple areas and its sales growth flatlined.

Palmisano's successor, Ginni Rometty, weaned IBM off its dependence on buybacks and pursued more forward-thinking acquisitions. These acquisitions, particularly its acquisition of SoftLayer in 2013, let IBM focus on the growth of its "strategic imperatives" (the cloud, analytics, security, mobile, and social businesses) to offset the slower growth of its legacy IT services, software, and hardware businesses.

IBM integrated a myriad of next-gen technologies -- including its Watson AI platform, a blockchain service, and quantum computing tools -- into that ecosystem. It also emphasized its goal of becoming a market leader in the hybrid cloud market, which bridges the public and private cloud markets for companies that aren't ready to move all their data to public cloud services like Amazon (AMZN 1.12%) Web Services (AWS) or Microsoft's (MSFT -0.26%) Azure.

Check out the latest earnings call transcript for IBM.

A network of cloud computing connections.

Image source: Getty Images.

IBM's turnaround plan sounded promising, but the growth of its strategic imperatives, which generated half its revenue over the past 12 months, decelerated over the past year:

Strategic Imperatives

Q1 2018

Q2 2018

Q3 2018

Q4 2018

Trailing-12-month revenue

$37.7 billion

$39.0 billion

$39.5 billion

$39.8 billion

Growth (YOY)

12%

15%

13%

9%

Data source: IBM quarterly reports. YOY = year over year.

That deceleration ended IBM's brief streak of positive sales growth between the fourth quarter of 2017 and the second quarter of 2018:

IBM

Q1 2018

Q2 2018

Q3 2018

Q4 2018

Revenue growth (YOY)

5%

4%

(2%)

(3%)

Non-GAAP EPS growth (YOY)

4%

5%

5%

(5%)

Data source: IBM quarterly reports. EPS = earnings per share.

That slowdown indicated that the growth of IBM's strategic imperatives still couldn't fully offset the slowdown of its legacy businesses. Analysts expect IBM's revenue to decline 2% this year as its non-GAAP earnings rise less than 1%.

That downbeat forecast can be attributed to three main factors. First, IBM is struggling to compete against AWS and Azure in the cloud services space. IBM's cloud services revenue rose 18% annually last quarter, but that rate pales in comparison to the growth rates of AWS and Azure. Second, demand for its IBM Z mainframe systems is currently at a cyclical low. Lastly, the strong dollar is throttling IBM's growth. On a constant currency basis, its revenue dipped just 1% during the fourth quarter.

Betting big on Red Hat

IBM believes that its acquisition of Red Hat, which should close in the second half of 2019, will boost its revenue by a compound annual growth rate of 200 basis points over the next five years. In other words, buying Red Hat could enable IBM to consistently generate positive sales growth again.

Moreover, the integration of Red Hat's open source Linux OS, JBoss enterprise middleware, and cloud-based virtualization services could significantly strengthen IBM's business software and cloud ecosystems. That strategy appears solid on paper, but it could be tough to execute amid tough competition from Amazon, Microsoft, and other rivals.

Still in the penalty box

IBM's stock is cheap because investors don't see any promising signs of a turnaround yet. Unless the growth of its strategic imperatives accelerates again, IBM will likely stay in the penalty box until it closes its purchase of Red Hat and successfully absorbs its products.

Investors who want a high dividend should probably consider buying other classic dividend stocks before turning to IBM, while investors who are seeking higher-growth cloud plays should stick with Amazon or Microsoft instead.

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool's board of directors. Leo Sun owns shares of Amazon. The Motley Fool owns shares of and recommends Amazon. The Motley Fool owns shares of Microsoft. The Motley Fool is short shares of IBM. The Motley Fool has a disclosure policy.

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Stocks Mentioned

International Business Machines Corporation Stock Quote
International Business Machines Corporation
IBM
$136.56 (1.21%) $1.63
Microsoft Corporation Stock Quote
Microsoft Corporation
MSFT
$292.71 (-0.26%) $0.76
Amazon.com, Inc. Stock Quote
Amazon.com, Inc.
AMZN
$144.78 (1.12%) $1.60
Red Hat, Inc. Stock Quote
Red Hat, Inc.
RHT

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