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Better Buy: Microsoft vs. IBM

By Will Healy – Jun 15, 2020 at 9:49AM

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Which cloud company offers investors higher returns?

The competition between Microsoft (MSFT 3.38%) and International Business Machines (IBM 3.28%) is now a pairing of cloud titans. Microsoft elevated the head of its cloud division to CEO in 2014. IBM followed suit this past April. 

Microsoft has worked for some years to redefine itself as a cloud company. Although IBM has recently made the same moves, it is years behind the software giant. This poses a significant question for investors in technology stocks -- do they choose the established business of Microsoft or a stake in IBM's still-developing cloud business?

The two cloud businesses

Gartner Research predicts cloud revenue to grow worldwide by 17% in 2020, with double-digit growth continuing through at least 2022. This trend should bode well for both companies as they seek to attract the business of a fast-growing group of customers. The question investors must answer is which company will bring them the highest return?

Cloud symbol with a conceptual design and planet Earth in the background.

Image source: Getty Images.

Microsoft CEO Satya Nadella orchestrated a comeback in the software giant. According to WordPress hosting platform Kinsta, Microsoft lags behind only Amazon's Amazon Web Services (AWS) in the infrastructure-as-a-service (IaaS) space. Investors should also note that Microsoft Azure saw 62% revenue growth year-over-year in the last quarter. This compares to 32.8% growth for AWS.

IBM's growth rate lags behind both. In the most recent quarter, IBM grew overall cloud revenue by 19%. Although CEO Arvind Krishna has only held the leadership role since April, he heavily influenced IBM's decision to purchase Red Hat in 2019. Hence, this tech giant, which has redefined itself numerous times in its over 100-year history, may become a major player in the cloud.

Moreover, because IBM saw an overall revenue decline, Krishna has worked to pare down underperforming divisions. Soon after taking over, he announced layoffs across multiple divisions. While the company blamed the pandemic for the job cuts, the desire to orient itself around cloud, security, and analytics services likely drove the layoffs. As a result, the future of IBM stock will likely depend on how well Krishna succeeds in redefining IBM.

Financials

The question is, how much will that shift boost IBM stock? Time will tell, but the adage that you get what you pay for applies to both companies. Regarding forecasted growth, Microsoft is the clear winner. Analysts predict earnings growth will average about 15.2% per year over the next five years at Microsoft. During the same period, analysts predict profit increases of about 3.9% per year for IBM.

However, that higher growth will cost investors. Those who buy Microsoft will pay a forward P/E ratio of approximately 31.4. Currently, IBM trades at about 12.0 times forward earnings.

Financial Metrics Microsoft IBM
Forward P/E ratio 31.4 12.0
Five-year average earnings growth 15.2% 3.9%
Annual dividend (per share) $2.04 $6.52
Dividend yield 1.1% 5.4%

DATA SOURCE: MICROSOFT CORPORATION, IBM CORPORATION, MORNINGSTAR, YAHOO! FINANCE.

IBM will also yield investors significantly more dividend income. For Microsoft, this year's dividend amounts to an annual payout of $2.04 per share. The payout ratio, or percentage of net profit going to the dividend, is about 32.3%. Although Microsoft should have no trouble covering this expense, that takes the yield to just under 1.1%. The payout has also steadily risen since Microsoft paid its first dividend in 2003.

However, IBM is on track to pay shareholders $6.52 per share for the year. That brings IBM's dividend yield to almost 5.4%. Also, for IBM, this year's annual increase was the 25th in a row, making IBM the newest Dividend Aristocrat. Moreover, since the company worked for 25 years to achieve this status, even a payout ratio of approximately 64.2% is unlikely to compromise the streak of dividend increases.

Microsoft or IBM?

The choice between Microsoft and IBM comes down to risk tolerance. The risk averse will do well with Microsoft. Although it has become expensive, the double-digit profit growth rate should keep its stock moving higher long term.

However, those with some level of risk tolerance will probably see higher returns with IBM. From a P/E ratio versus a growth perspective, Microsoft holds a slight edge. However, growth for IBM will likely rise further as Krishna seeks to de-emphasize or sell lower-performing divisions.

Additionally, IBM investors should see the already-generous cash return increase further as the company seeks to maintain its Dividend Aristocrat status. As long as the cloud brings IBM some level of success, the dividend should remain safe despite its size.

Buying IBM is a gamble that Krishna can follow in Nadella's footsteps. However, even if IBM only enjoys partial success, investors will more than likely see higher returns in Big Blue.

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
$125.50 (3.28%) $3.99
Microsoft Corporation Stock Quote
Microsoft Corporation
MSFT
$248.88 (3.38%) $8.14

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