On Jan. 21, IBM (NYSE:IBM) reported fourth-quarter earnings for 2019. Following the close of its Red Hat acquisition on July 9, 2019, this was the second full quarter with Red Hat consolidated in its results. Then this week, Big Blue announced its CEO Ginni Rometty was stepping down.
With a $34 billion price tag, IBM made a big bet on Red Hat based on the premise it would accelerate IBM's efforts in the cloud. Red Hat is the leading provider of hybrid cloud solutions, a rapidly growing sub-sector of the overall cloud industry. Together, IBM and Red Hat's hybrid multi-cloud platform offerings allow businesses to securely deploy, run, and manage data and applications on-premises and on private and multiple public clouds. The acquisition was supposed to be symbiotic; Red Hat would open up the hybrid market and its customer base to IBM, and IBM's incumbency and scale would help accelerate Red Hat's growth.
Six months in, investors are looking to see any signs that this plan is paying off for the tech stock.
Let's get right to the heart: cloud growth
On its fourth-quarter conference call, management was surprisingly upbeat. Specifically, Red Hat's revenue growth accelerated 24% year-over-year. This is significant as it was stronger than the third-quarter growth rate of 20% and the 16% growth before the acquisition.
Even more significant is that Red Hat appears to be propelling IBM's cloud revenue growth forward too Remember that symbiotic relationship? IBM's total cloud revenue growth accelerated to 23% year-over-year in constant currency. This is an increase from the 14% growth reported in the third quarter. IBM's cloud revenue growth grew almost as fast as Red Hat's, which is a positive sign.
IBM said "new Red Hat engagements" were expanding, and "our cloud revenue for the year was $21 billion. By leveraging our technology, incumbency and expertise to help our clients with their journeys to cloud, it now represents 27% of our revenue." That 27% figure is for the full year, but with its cloud business growing substantially faster than the rest of IBM, and with a boost from Red Hat, cloud is quickly growing as a percent of sales and represented 31% of sales in the fourth quarter.
If a $34 billion acquisition doesn't convince investors that IBM is committed to the cloud, on Jan. 30 after the market close, IBM announced that Rometty plans to step down in April. IBM's Senior Vice President for Cloud and Cognitive Software, Arvind Krishna, will become the new CEO. Krishna was a principal architect of the company's acquisition of Red Hat, which speaks volumes to how IBM feels about the early success of the transaction. The board of directors announced James Whitehurst, CEO of Red Hat, was elected as IBM's president, also effective in April. Krishna has been with IBM for nearly 30 years, while Whitehurst came with the Red Hat acquisition less than a year ago. This new duo at the top is an exciting selection by the board to say the least.
Is a return to sustainable revenue growth possible?
The good news for IBM is that almost one-third of its business is growing at over 20%. That's meaningful. Why? Consider that when 30% of your business grows at a 20% rate, if the rest of your business remains flat, overall revenues would grow 6%. That would be a significant improvement in top-line growth for IBM compared to the modestly declining revenue growth it's been experiencing.
More good news is that its systems segment seems to have turned a corner. The systems segment houses IBM's old legacy mainframe computing business. But a new product cycle is underway and is off to a strong start. Total systems revenues for the fourth quarter grew 16% year over year versus a decline of 14% last quarter. The systems segment accounts for another 7% of revenue. Thus, combined with the cloud business, close to 40% of IBM's revenue is growing at a healthy clip.
The problem is that remaining 60% of revenue, which collectively declined 9% in the fourth quarter. The largest problem is the global technology services (GTS) segment which accounts for about half of the decline and operates at a single-digit profit margin, the lowest of IBM's four business units. The GTS business is the technical consulting arm of IBM helping businesses design, build, and run technical solutions for their businesses.
Despite the current weak operating environment, the GTS segment still plays an integral role for IBM. GTS has an industry-leading market share position, global footprint, and scale, and most importantly, IBM says it's central to "the integrated value proposition of IBM overall as we run the mission critical workloads for many of our clients overall."
CFO James Kavanaugh commented on the segment:
We are going to take aggressive actions around our GTS business model...we are going to integrate our go-to-market with GBS (Global Business Services) and our global account teams at the large enterprise level. We're going to take these integrated offerings, leverage now the integrated value and breadth of IBM that can play across the continuum as clients move to journey to the cloud...And we're going to go drive that hard. And in addition, I would tell you, we are going to improve the cost competitive structure of this business with the actions we're going to take here early in 2020.
This business is still a work-in-progress, but the right assets are in place. Hopefully, progress will be seen this year.
Strong guidance and low expectation makes for a nice setup
Its 2020 guidance included growth in revenues, gross margins, operating EPS, and free cash flow. Specifically, operating EPS is expected to grow 4% to $13.35 per share, basically in-line with the consensus of analysts' estimates, but helped by a lower than expected tax rate of 7% to 9%. Free cash flow is expected to grow 5% to $12.5 billion, more than double the dividend payout, and includes growth in capital expenditures for cloud investments. Further, the balance sheet continues to strengthen as IBM has now repaid $10 billion in debt since the closing of the Red Hat acquisition when total debt peaked at $73 billion.
Going forward, IBM needs to execute on two things: continuing to show strong revenue growth in cloud and improving performance of the GTS business. The combination of these two things will allow IBM to return to sustainable mid-single-digit top-line growth.
IBM still carries low expectations in the marketplace. Trading at just over 10 times forward earnings and offering a dividend yield north of 4.5%, not much is baked in for a reacceleration of growth. But if IBM can show continued progress over the next few quarters, 14 to 15 times 2020 earnings of $13.35 is not unrealistic. Investors who buy IBM today could see the stock price approach $200 per share by the end of the year, representing upside of more than 40%.