IBM's (IBM -0.01%) stock has declined about 16% over the past five years, woefully underperforming the S&P 500's 75% gain. Even after factoring in reinvested dividends, IBM's stock only delivered a total return of 3%.
Let's evaluate Big Blue's mistakes and its turnaround strategies, and see if it can finally generate stronger returns over the next five years.
What happened to IBM?
Many of IBM's current problems started under Sam Palmisano, who served as the tech giant's eighth CEO from 2002 to 2012. IBM bought PwC's consulting business in 2002, sold its PC business to Lenovo (LNVGY 3.01%) in 2005, and relied heavily on cost-cutting measures and buybacks to boost its earnings.
Palmisano largely ignored the rise of public cloud platforms, including Amazon (AMZN -0.11%) Web Services (AWS) and Microsoft (MSFT 1.01%) Azure, which would eventually disrupt the enterprise software market with cloud-based services.
By the time Ginni Rometty succeeded Palmisano, IBM's revenue growth had flatlined and the company was addicted to buybacks. Rometty shifted gears and divested IBM's weaker businesses, including its server segment; expanded its cloud presence with big acquisitions like SoftLayer; and prioritized its higher-growth "strategic imperatives" (cloud, mobile, security, analytics, and social) to offset the slower growth of its software, hardware, and IT services segments.
Unfortunately, IBM's revenue continued declining as the sluggishness of its legacy businesses -- many of which were being disrupted by competing cloud services -- overwhelmed the growth of its own cloud businesses:
A new CEO and a new strategy
Rometty's final major decision as IBM's CEO was its $34 billion takeover of Red Hat, which closed last July. Rometty believed that Red Hat's open source software would enable IBM to provide more cloud and AI services for hybrid cloud deployments, which link together public cloud services (like AWS and Azure) with on-site private clouds.
Arvind Krishna, IBM's cloud chief, took over as CEO earlier this year and pledged to lead Big Blue on "two major transformational journeys" in the hybrid cloud and AI markets. Krishna recently took the first major step by spinning off its managed infrastructure services unit into a new company.
That split, which is expected to close by the end of 2021, will allow IBM to focus on the higher-growth cloud and AI markets without being burdened by its slower-growth IT services segment. Meanwhile, the stand-alone IT business can focus on cutting costs and investing in its own growth instead of subsidizing IBM's higher-growth businesses.
The new IBM will focus on expanding in the hybrid cloud market with its own services and Red Hat's open source software. Instead of directly challenging AWS or Azure in the public cloud market, IBM will plug its open source solutions between those public cloud platforms and private clouds, and provide more tools to crunch and analyze all that data.
Focusing on growth instead of dividends
The streamlined IBM could benefit from the growth of the hybrid cloud market, which it considers a $1 trillion market opportunity, and post stronger revenue and earnings growth in 2022 and beyond.
But that success isn't guaranteed. Amazon, Microsoft, and other public cloud leaders are also offering more services for hybrid cloud deployments. These solutions could seal the gap between public and private clouds and make it tougher for IBM and Red Hat to deploy their hybrid cloud services.
IBM became a Dividend Aristocrat of the S&P 500 after it raised its dividend for the 25th straight year this April, but it will likely lose that elite title after the split. IBM claims the two new companies will pay a "combined" quarterly dividend that is "no less" than IBM's current dividend.
Therefore, investors might need to retain their shares in both the new IBM and the slower-growth IT company to receive the same amount of dividends.
Where will IBM be in five years?
IBM has been a disappointing investment over the past five years, but the next five years could be brighter as it jettisons its sluggish IT services business, expands its higher-growth cloud and AI services, and worries less about dividends and buybacks.
Investors should maintain realistic expectations for a turnaround, since the company still faces tough competition in the hybrid cloud market, but IBM could succeed if it leverages Red Hat's leading position in open source software and its own strengths in enterprise software to lock in more customers.
IBM's stock is already cheap at 11 times forward earnings, and its multiple should remain low after the split. Therefore, I believe the stock's downside potential is limited, and it should gradually rise over the next five years as Krishna aggressively transforms the slimmer IBM.