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Is IBM Stock a Buy?

By Herve Blandin – Jul 22, 2020 at 10:18AM

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It depends on its growing hybrid cloud business.

In contrast with many innovative cloud players that have been posting high revenue growth over the last several years, the debt-loaded tech giant International Business Machines (IBM -2.32%) revealed unexciting second-quarter results on Monday with declining revenue and earnings per share. In addition, management still hasn't provided full-year guidance because of the coronavirus-induced uncertainties.

However, IBM's transition to the cloud is materializing, and the market values the company at a modest forward earnings multiple of 11.9. Given this contrasted situation, is IBM stock a buy? 

Hidden cloud growth amid total revenue decline

Second-quarter revenue of $18.1 billion exceeded analysts' forecasts by $403 million, but it still dropped by 5.4% year over year. Granted, taking into account divestitures and currency impact, that revenue decline improved to 1.9%. That performance remains modest, though, as revenue was boosted by $867 million of extra contribution from IBM's $34 billion Red Hat acquisition in July 2019. 

Cloud image on blurred computer data center background.

Image source: Getty Images.

During the earnings call, CFO Jim Kavanaugh indicated that some of the company's businesses suffered as many customers prioritized operating expenses over long-term projects. For instance, revenue from IBM's transaction processing platforms dropped by 14% year over year to $1.7 billion because of the coronavirus-induced challenging economic environment.

However, in contrast with these weak short-term results, the company's shift to the cloud is materializing. Total year-over-year cloud revenue growth accelerated to 34% at constant currency, up from 23% during the previous quarter. And with $6.3 billion of revenue during Q2, cloud represented 34.8% of total revenue, up from 25% one year ago. The key element to these strong results comes from the company's focus on hybrid cloud.

Focus on hybrid clouds

A hybrid cloud solution is a solution that can run on any combination of public and private clouds, which allows developers to build software solutions that don't depend on the choice of cloud providers.

IBM's transition to hybrid clouds represents a significant growth opportunity. A study from the research outfit IDC anticipates that 90% of companies worldwide will rely on multiple clouds by 2022. IBM estimates the hybrid cloud market opportunity at $1.2 trillion, with almost half of it translating into services that could leverage the company's consulting business.

Thanks to its acquisition of Red Hat, IBM is poised to remain relevant in the hybrid cloud market. IBM's hybrid cloud offering is based on Red Hat's container and Kubernetes technologies that became standards in cloud environments. And Red Hat's platform OpenShift glues these technologies together with its management and integration functionalities.

In addition, the acquisitions of Spanugo and WDG Automation announced over the last couple of months will reinforce IBM's cloud portfolio with extra cybersecurity and artificial intelligence (AI) capabilities.

Attractive upside potential

Despite IBM's transition into this attractive hybrid cloud opportunity, the market seems to value the company based on its disappointing past results. Its market capitalization represents only 10.2 times its trailing 12-month free cash flow of $11.5 billion.

Granted, its net debt -- total debt minus total cash and marketable securities -- of $50.4 billion at the end of last quarter, down from $53.9 billion at the end of 2019, remains significant. But the dividend represents an annualized cash outflow of $5.8 billion, which allows net debt reduction without threatening the company's Dividend Aristocrat status (at least 25 consecutive years of increasing dividends). IBM also maintained over $15 billion in undrawn credit in addition to its $14.3 billion of cash and marketable securities.

Since IBM's valuation doesn't seem to take into account its exposure to the huge hybrid cloud opportunity, IBM stock price upside potential should materialize if the tech giant's cloud businesses keep on delivering solid revenue growth. Given the company's strong portfolio in this area thanks to its Red Hat acquisition, the risk-reward ratio looks attractive, and I consider IBM stock a buy.

Herve Blandin owns shares of IBM. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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