International Business Machines (NYSE:IBM) announced an intriguing spinoff this week to accelerate its cloud and artificial intelligence (AI) growth strategy. Whether the spinoff will generate operational benefits remains to be seen, but Big Blue shareholders should still profit from this decision.

What will IBM spin off and why

Over the last several years, the tech giant has been shifting its business to the cloud to offset the decline of its legacy activities. It accelerated that transformation with the acquisition of cloud specialist Red Hat for $34 billion in 2019. As a result, trailing-12-month (TTM) cloud revenue of $23 billion represented 30% of total revenue at the end of last quarter, up from 2% in 2012.

Yet because of divestitures and struggling legacy businesses, revenue dropped from $105 billion in 2012 to $76 billion over the last 12 months.

So management went a step further with its strategy: It announced last Thursday that it will spin off part of its global technology services (GTS) segment into a new public company called NewCo -- until it finds a better name.

Put simply, NewCo will correspond to IBM's legacy consulting services for the management and outsourcing of customers' data centers and computing infrastructures. TTM revenue for this business was $19 billion at the end of Q2. Post-spinoff IBM -- with $59 billion of TTM revenue -- will focus on hybrid cloud (any combination of public and private cloud) and AI.

Cloud on blurred computer data center background.

Image source: Getty Images.

With this spinoff, management aims to unlock growth opportunities by having both entities focus on their respective core businesses, thanks to their simplified structures.

However, there's a flip side to this. Even if both companies continue to operate under a strategic relationship, NewCo will have more freedom to partner with IBM's competitors, and synergies with IBM may diminish because of reduced cross-selling and integration opportunities. Also, the two new entities may have higher general and administrative expenses than today's IBM because of reduced scale and synergies.

IBM and NewCo valuations 

Besides those uncertain operational benefits, IBM shareholders -- who will keep their IBM shares and receive NewCo shares -- may still profit from the spinoff: The market may upgrade IBM's post-spinoff valuation while still pricing NewCo like today's IBM.

IBM has a low valuation, with forward price-to-sales (P/S) and price-to-earnings (P/E) ratios of 1.6 and 11.8, respectively, corresponding to modest expectations that would fit NewCo's potentially weak top line and heavy debt load.

Indeed, NewCo's business will represent a significant part of IBM's GTS revenue, which decreased by 6.1% to $27.3 billion in 2019 because of declining legacy activities. And since NewCo won't include GTS' growing public cloud business, it is unlikely to generate revenue growth over the medium term.

Management didn't reveal exactly how it will allocate IBM's total debt of $64.7 billion at the end of Q2 between both entities, but it indicated that it was aiming for an investment-grade rating for NewCo while maintaining a better "single A" credit rating for IBM. That suggests NewCo will get a pretty heavy debt burden.

Besides, after an initial combined dividend that will correspond to at least IBM's current dividend, both entities will independently update their policies. And given its poor top-line growth prospects and weaker balance sheet, NewCo may be unable to increase its dividend after the spinoff.

In contrast, management anticipates post-spinoff IBM to generate mid-single-digit revenue growth over the medium term. Given that it is expected to have a strong balance sheet and long-term growth opportunities with its hybrid cloud and AI businesses, the market may perceive post-spinoff IBM as a growth stock, which would imply a higher valuation.

Looking forward

IBM's spinoff should close by the end of 2021. Before a potential spinoff-induced share price increase materializes, shareholders should focus on IBM's transition to the cloud, as it remains an important driver for the company's success. 

In the short term, there are no surprises. The preliminary Q3 results the company communicated on Thursday corresponded to analysts' expectations, with estimated revenue of $17.6 billion and non-GAAP (adjusted) earnings per share of $2.58. IBM should release its Q3 results on Oct. 19.