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Is IBM Ready for a Big Surge?

By Greg Jones – Nov 24, 2019 at 7:00AM

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IBM is lagging behind its technology peers. But its acquisition of Red Hat earlier this year may be a game changer.

For most of the 108 years that it has been in existence, IBM (IBM 0.50%) has been synonymous with growth, innovation, and a rising stock price. Since the start of the millennium through 2013, IBM's shares trounced the S&P 500. This hasn't been the case in recent years, however.

Since 2014, IBM's earnings and share price has floundered. With a relatively high dividend yield and little growth, IBM has acted more like an old economy utility stock rather than a high-flying technology stock.

Circuit board with a picture of a cloud on a component

Image source: Getty Images.

Out in the wilderness

The source of IBM's recent issues has been the emergence of cloud technology, which has upended many of the company's legacy businesses. Although IBM has since embraced the technology, its share of the cloud infrastructure market as of the fourth quarter of 2018 has remained relatively muted at 3.6%. By comparison, Amazon AWS and Microsoft Azure claim market shares of 32.3% and 16.5%, respectively.

Although IBM's earnings have fallen, a look below the surface highlights several disparate trends. First, IBM's legacy business continues to lose traction. What has buoyed overall earnings, however, has been its strategic imperatives focus -- IBM's initiatives aimed at emerging technologies such as the cloud, cybersecurity, and artificial intelligence (AI) -- which now accounts for over 50% of sales, nearly double the level in 2014.

Setting the next stage for growth

With IBM's strategic imperatives starting to bear fruit, its earnings look to be on firmer ground. However, the company decided to take an even more drastic step. To jump-start its efforts in accessing the $1.2 trillion hybrid cloud market, IBM purchased Red Hat in 2019 for $34 billion, picking up the world's largest open-source technology provider for the enterprise with its largest acquisition to date. Although it will take a number of years to judge the success of this transaction, the early signs look encouraging. In the most recent quarter, Red Hat's contribution to IBM's results were stronger than expected with revenue rising 20%.

IBM is in a good position to leverage its stronger suite of cloud products and services. It sells to 95% of the Fortune 500 companies and manages much of the world's business data. As the purest play in hybrid cloud courtesy of the Red Hat acquisition, IBM stands to benefit from the next stage in digital reinvention.

At a little over 10 times earnings, IBM is currently priced for little or no earnings growth. Any positive change to the earnings trajectory would likely be accompanied by a higher multiple. Although it's difficult to judge when this is likely to happen, an investor in IBM can in the meantime feel gratified by a dividend yield approaching 5% with the potential for higher dividends ahead. IBM has raised its dividend for 24 consecutive years.

If synergies with Red Hat are fully realized, Morgan Stanley believes the bull case for IBM could take the share price to $197, representing an upside of over 40% from current levels. Under-owned and unloved, Big Blue may be set for some big surprises.

Greg Jones owns shares of IBM. The Motley Fool is short shares of IBM. The Motley Fool recommends the following options: long January 2020 $200 calls on IBM, short January 2020 $200 puts on IBM, and short January 2020 $155 calls on IBM. The Motley Fool has a disclosure policy.

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