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Where Will IBM Be in 1 Year?

By Will Healy – May 1, 2020 at 11:12AM

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Uncertainty and promise are in the picture.

International Business Machines (IBM -2.79%) is at a critical juncture. Arvind Krishna, formerly senior vice president of the company's cloud and cognitive software division, took over as CEO on April 6, taking the helm at a time when declining revenue from legacy businesses has led to reduced profits and a stock that has fallen nearly 50% from its 2013 high.

Under previous CEO Ginni Rometty, the company made strides toward transitioning itself into a cloud company. This culminated in the $34 billion purchase of Red Hat in 2019. Now, with Krishna leading the company, this tech stock has effectively bet its future on the cloud. Hence, where IBM stock will trade one year from now will likely hinge on how well Krishna executes this strategy, though the COVID-19 pandemic has injected uncertainty into the picture. Still, with recent opportunities in the cloud coming to light, investors might find an opportunity in IBM stock.

Coronavirus effects not yet clear

Krishna goes into the CEO job at a difficult time for both the company and the country. The COVID-19 pandemic has brought many segments of the economy to a standstill. With no idea when coronavirus infections will level off or a timeline on a vaccine, IBM operates in an environment of uncertainty. 

For the most recent quarter -- ended March 31 -- overall revenue fell by 3.4%. Operating earnings of $1.84 per share represented an 18.2% drop from the $2.25 per share earned in the same quarter last year.

With the novel coronavirus not becoming a factor until near the end of the quarter -- the pandemic was declared on March 11 and California instituted the United States' first statewide shelter-in-place order on March 19 -- the effect of the virus on IBM's revenue isn't totally known. So uncertain is the effect that the company pulled guidance for fiscal 2020. 

Artist's rendering of a circuit board with a lit, elevated motherboard in the center with a cloud icon

Image source: Getty Images.

The cloud can (maybe) lead the way

Despite the uncertainty, we know that revenue in IBM's cloud and cognitive software segment rose by 7% in the quarter. This is the division previously run by Krishna. It includes Red Hat and allows clients to manage their apps and data from any location. It also has probably benefited from the pandemic as more workers perform tasks remotely. Also, analysts at Gartner project 17% growth in cloud computing services in 2020, with few signs of a significant slowdown. Hence, this division will likely continue to deliver positive growth. 

The other division to grow revenue was the systems segment, which saw a 4% increase. Systems includes the company's supercomputing capabilities as well as servers and storage. 

These two divisions made up $6.6 billion of the company's $17.6 billion in revenue in the quarter, slightly more than one-third.  

These divergent paths may also represent the emergence of two IBMs -- one made up of the cloud and systems divisions and the "other IBM" consisting of three legacy divisions. The business services division helps to integrate different technologies to design solutions for the needs of a specific business. Technology services, the largest source of revenue among the divisions, provides storage-as-a-service to its customers, and global financing allows customers to pay for IBM products and services.

The pandemic could dampen the demand for both business services and global financing amid a slower economy. Since technology services operates in the cloud, it holds more potential to return to positive revenue growth. Still, with the novel coronavirus likely to harm the IBM consisting of legacy businesses, it remains unclear which IBM will have a more significant effect on the company's revenue and earnings.

The case for cautious optimism

Despite this uncertainty, investors have some compelling incentives to consider IBM stock. For one, the current price-to-earnings (P/E) ratio stands at just under 12.5 as of the time of this writing. This comes in below the five-year average multiple of 14.6. 

Admittedly, the company will probably offer meager earnings growth; analysts project profit growth will average 3.92% per year over the next five years. Also, with the added uncertainty of no forward guidance, IBM stock has become cheap for a reason in many respects.

However, with the continued growth of the cloud, investors may see IBM as a way to buy a cloud stock at a low valuation. At the height of the pandemic, the cloud has shown itself as a valuable link for both work and families. According to technology research company Canalys, Amazon and Microsoft lead the way in the cloud industry but assuming IBM can take some of the growth for itself, that could conceivably boost IBM stock.

Moreover, the company continues to pay a generous dividend. This current annual payout of $6.52 amounts to a yield of approximately 5.2% at the current stock price. With the most recent dividend increase -- announced April 28 -- IBM now claims the 25 years of increases needed to achieve Dividend Aristocrat status. Reaching that milestone will probably attract interest from both funds and income-oriented investors.

Furthermore, the payout ratio of about 58.2% represents a significant but not overwhelming cost to the company. This still leaves around 41.8% of profits left that it can use to reinvest in the company, repurchase shares, or hike the dividend. Hence, I would expect a higher payout one year from now, and further increases in the years to come.

Meager profit growth and uncertainty as to whether IBM can redefine itself as a cloud company have long weighed on IBM stock. However, the novel coronavirus will probably not stop the growing popularity of cloud offerings. Moreover, with a low valuation, a generous dividend payout, and apparently secure dividend, investors have a case for cautious optimism with IBM stock.

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. Will Healy has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Amazon and Microsoft. The Motley Fool recommends Gartner and recommends the following options: long January 2021 $85 calls on Microsoft, short January 2021 $115 calls on Microsoft, short January 2022 $1940 calls on Amazon, and long January 2022 $1920 calls on Amazon. The Motley Fool has a disclosure policy.

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Stocks Mentioned

International Business Machines Corporation Stock Quote
International Business Machines Corporation
IBM
$122.23 (-2.79%) $-3.51
Microsoft Corporation Stock Quote
Microsoft Corporation
MSFT
$246.79 (-0.97%) $-2.41
Amazon.com, Inc. Stock Quote
Amazon.com, Inc.
AMZN
$120.30 (-0.54%) $0.65
Gartner, Inc. Stock Quote
Gartner, Inc.
IT
$300.76 (0.33%) $0.98

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