International Business Machines (IBM -0.32%) managed to beat expectations with its fourth-quarter report last week, and it provided guidance calling for revenue and earnings growth in 2020. The stock has been trending downward for years as the company's transformation failed to translate into sustainable growth. That painful period may finally be over.
While looking at IBM's stock chart doesn't foster much confidence, there are a few good reasons to buy the stock.
1. Red Hat
IBM loaded up its balance sheet with debt to acquire open source software company Red Hat. While there's no guarantee that the $34 billion deal won't end in write-offs and disappointment, Red Hat presents IBM with some significant growth opportunities.
Red Hat itself was growing at a solid double-digit rate prior to the acquisition. Red Hat Enterprise Linux accounted for about one-third of the paid enterprise operating system market in 2018, second only to Microsoft. And Red Hat OpenShift, the company's container-based platform for hybrid cloud, currently leads the market.
The Red Hat acquisition strengthened IBM's position in the hybrid cloud market on day one. The combination of IBM and Red Hat is powerful, because IBM now has the opportunity to pitch Red Hat software to its large clients. Red Hat's normalized revenue growth rate accelerated to 24% in IBM's fourth quarter as that benefit began to be realized. One example: IBM recently announced a $1 billion hybrid cloud deal with a major Spanish bank involving Red Hat's OpenShift platform.
While IBM paid a steep price for Red Hat, the deal may end up being the key to IBM's return to sustainable growth.
2. A pessimistic stock price
IBM grew its revenue in the fourth quarter, and it expects revenue growth in 2020. Earnings are being pressured by the accounting treatment of Red Hat's pre-acquisition deferred revenue, but IBM stock looks cheap even including that headwind.
For 2020, IBM expects to generate adjusted earnings per share of at least $13.35. This number includes the impact of IBM being unable to recognize all of Red Hat's stand-alone revenue. Free cash flow is expected to be around $12.5 billion, up from $11.9 billion in 2019.
With the stock trading around $139, both the price-to-earnings ratio and price-to-free cash flow ratio are right around 10. That's a valuation that assumes little or no growth. IBM expects to grow its adjusted pre-tax income by a high single-digit percentage annually through 2021, factoring in the benefits of Red Hat. If the company can hit that target, it could earn the stock a higher multiple.
A cheap price alone isn't enough to make a stock a good investment. But combine the beaten-down valuation with the growth potential afforded by Red Hat, and IBM looks like a good value.
3. Almost a Dividend Aristocrat
IBM temporarily halted share buybacks once the Red Hat acquisition closed in order to prioritize paying down its debt. The company remains committed to growing the dividend, though, and another increase is expected in April.
Assuming IBM does raise its dividend in a few months, the company will become a Dividend Aristocrat, having increased its dividend for 25 consecutive years. IBM has paid dividends uninterrupted for over 100 years.
IBM's next dividend increase will likely be small, but a high yield makes up for the sluggish growth. The current quarterly dividend of $1.62 per share represents a yield of about 4.7%.
IBM is not a growth stock. Slow and steady growth is likely the best investors can hope for, but that's perfectly fine if the price is right. With IBM trading at pessimistic levels and sporting a high-yield dividend, growth doesn't need to be spectacular for the stock to be a winner over the next few years.