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Are Brighter Days Ahead for IBM?

By Leo Sun – Feb 3, 2020 at 12:20PM

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Has Big Blue finally reached an inflection point after years of stagnation?

Shares of IBM (IBM -2.08%) recently rallied after its fourth-quarter numbers beat analysts' expectations. Its revenue rose 0.1% annually to $21.78 billion (up 3% after excluding currency impacts and divested businesses), clearing estimates by $160 million and ending five straight quarters of declines.

Its non-GAAP earnings declined 3% to $4.71 per share, but still topped estimates by three cents. Its GAAP earnings, which faced an easy comparison due to tax-related charges a year earlier, surged 91% to $4.11 per share.

CEO Ginni Rometty, who has led IBM since 2012, also announced that she would resign on April 6 and hand the reins over to Arvind Krishna, the chief of IBM's Cloud and Cognitive Software division. Krishna's promotion and IBM's takeover of Red Hat, which closed last July, suggest that the tech giant plans to aggressively chase Amazon (AMZN -3.01%) and Microsoft (MSFT -1.27%) in the high-growth cloud market.

A network of cloud computing connections.

Image source: Getty Images.

So are brighter days ahead for IBM, which underperformed both tech giants over the past decade? Or will it continue to struggle against its faster-growing rivals with stickier ecosystems?

The key numbers

IBM generates its revenue from five core businesses: cloud and cognitive software, global technology services, global business services, systems, and global financing. Here's how they fared during the fourth quarter:

Segment

Percentage of revenues

YOY revenue growth

Cloud & Cognitive Software

33%

9.4%

Global Technology Services

32%

(4%)

Global Business Services

19%

(0.3%)

Systems

14%

16.5%

Global Financing

1%

(24.9%)

Source: IBM Q4 earnings report. Constant currency terms.

IBM's cloud and cognitive software revenue rose with its takeover of Red Hat, which grew its revenue 24% and accounted for 15% of the unit's top line. Its cloud, security, and IoT (Internet of Things) services also generated consistent growth.

Racks of servers in a data center.

Image source: Getty Images.

Its global technology services unit, which houses the cloud Iaas (infrastructure as a service) business -- which competes against Amazon Web Services (AWS) and Microsoft's Azure -- struggled with "lower client business volumes" during the quarter.

That's disappointing, since AWS and Azure posted 34% and 62% annual revenue growth, respectively, in their latest quarters. But it isn't surprising, since IBM ranked a distant fifth in the IaaS market with a 1.8% share in 2018, according to Gartner, putting it behind Amazon, Microsoft, Alibaba, and Alphabet's Google.

IBM's total cloud revenue rose 21% to $6.8 billion, or 31% of its top line, during the quarter, but most of that growth was driven by Red Hat and its private/hybrid cloud services instead of platforms that go toe-to-toe against Amazon and Microsoft.

IBM's business services grew its consulting revenue, but those gains were offset by the decline of its legacy IT services. However, the systems business posted strong growth as cyclical upgrades for its IBM Z mainframe and storage systems finally kicked in.

A return to growth under fresh leadership?

IBM expects the Red Hat acquisition, the expansion of its hybrid cloud business, and rebounding system sales to boost its revenue 4% to 5% in fiscal 2020. It also expects its non-GAAP EPS to grow 4%, and for its free cash flow (FCF) to rise 5% to $12.5 billion.

Those are solid growth rates, and IBM's forward P/E of 10 and its forward dividend yield of 4.5% could set a floor under its stock as its business stabilizes. It will also likely become a "Dividend Aristocrat" of the S&P 500 later this year with its 25th straight dividend hike.

IBM's promotion of Krishna to the CEO position mirrors Microsoft's promotion of Satya Nadella, who led the expansion of its cloud services, to CEO in 2014. Microsoft's stock surged roughly 370% since Nadella took the helm as the aging tech giant prioritized the growth of Azure, Office 365, Dynamics, and other cloud services over short-term profits.

Yet Krishna faces a tougher uphill battle than Nadella, for two reasons. First, IBM is shackled to more legacy businesses than Microsoft, which leveraged the strength of Windows and Office to grow its cloud businesses.

Second, IBM is entrenching itself in the private and hybrid cloud markets, but both AWS and Azure offer competing "virtual private clouds", which store data in isolated sections of the public cloud. Customers that want to use other AWS and Azure services could favor those solutions over IBM's hybrid platforms. In short, investors shouldn't assume that Krishna can turn Big Blue into a growth stock as Nadella did with Microsoft.

So are brighter days ahead for IBM?

Ginni Rometty reduced IBM's dependence on buybacks, divested weaker business units, and expanded the company's cloud presence by acquiring companies like SoftLayer and Red Hat. Those strategies enabled IBM to grow its revenue again, but its recovery remains fragile.

Brighter days could be ahead for IBM, but investors shouldn't expect a Microsoft-like rebirth. Krishna still needs to offset the slower growth of IBM's legacy businesses with its higher-growth ones, and make tough decisions, which could sacrifice its near-term profits for long-term growth.

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Suzanne Frey, an executive at Alphabet, 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 Alphabet (A shares), Alphabet (C shares), Amazon, and Microsoft. The Motley Fool recommends Gartner and recommends the following options: long January 2021 $85 calls on Microsoft and short January 2021 $115 calls on Microsoft. The Motley Fool has a disclosure policy.

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