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Is IBM Stock a Buy?

By Herve Blandin – Oct 22, 2020 at 8:00AM

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The third-quarter earnings call brought some important clarification about the company's short-term results and long-term goals.

International Business Machines (IBM -2.08%) had revealed preliminary third-quarter revenue and earnings when it announced the spinoff of its managed infrastructure services business on Oct. 8. Thus, the quarterly results announced this week didn't bring any surprise. But management shed some more light on Big Blue's near-term weak performance and long-term growth plans. Given those important clarifications, is IBM stock a buy?

Cloud remained strong

As analysts expected, IBM's third-quarter revenue dropped 2.6% year over year (or 3.1% adjusting for divested businesses and currency) to $17.6 billion -- the third consecutive quarter of revenue decline.

During the earnings call, management explained that second-quarter headwinds persisted during Q3: Some customers, especially in the retail, airline, and hospitality industries, paused their investments to prioritize operational stability and face the coronavirus-induced uncertainties. More importantly, these short-term challenges don't seem to correspond to a secular decline in demand for IBM's solutions and services, according to CFO Jim Kavanaugh.

In contrast, IBM's hybrid cloud business, which offers software solutions on any combination of public and private clouds, remained strong. In particular, Red Hat, acquired in 2019 for $34 billion to accelerate IBM's transition to the cloud, grew 17% year over year as customers embraced Red Hat's OpenShift platform to deploy their cloud software solutions.

As a result, cloud businesses kept growing as part of IBM's portfolio. Global cloud revenue increased by 19% to $6.0 billion, which represented 34.1% of the company's total revenue, up from 27.8% one year ago.

Cloud image with computer servers in background

Image source: Getty Images.

Investing in long-term growth

Given the coronavirus-induced uncertainties, management still didn't provide any guidance. In any case, you should expect IBM's cloud business to keep expanding over the long term.

The research outfit Forrester recently ranked Red Hat's multi-cloud container development platform -- a part of IBM's hybrid cloud solutions -- as a leader based on its offering and strategy. In addition, during the earnings call, Jim Kavanaugh repeated that the company will accelerate its investments in that hybrid cloud area to fuel its growth. And CEO Arvind Krishna confirmed mergers and acquisitions (M&A) as part of the company's arsenal to strengthen its portfolio.

Indeed, IBM must ramp up its investments to remain competitive in the cloud. Over the last several years, it spent a smaller percentage of revenue on its research and development (R&D) efforts compared to cloud giants such as Microsoft and Amazon. Granted, the comparison isn't straightforward, as the companies propose different cloud offerings and operate various other businesses. But as tech competitors have been scaling while IBM has been struggling with its top-line growth, the increasing investment gap between IBM and its tech peers represents a competitive threat over the long term.

As an illustration, IBM's trailing-12-month R&D expenses of $6.36 billion paled in comparison to Amazon's $19.3 billion and Microsoft's $38.7 billion.

IBM Research and Development Expense (% of Annual Revenues) Chart

IBM Research and Development Expense (% of Annual Revenues) data by YCharts

Thus, management's decision to invest in the company's growth areas instead of prioritizing short-term free cash flow represents a step in the right direction.

A cheap stock

Yet given the company's weak top-line performance, IBM stock is trading at only 10 times trailing 12-month free cash flow of $10.8 billion, which means the market doesn't expect any growth going forward.

Thus, IBM corresponds to an attractive opportunity to invest in a tech stock exposed to the cloud, artificial intelligence, and cybersecurity markets at a reasonable price. 

In addition, I recently argued that shareholders could benefit from the spinoff of IBM's managed infrastructure services business. The market may still price that legacy activity at today's IBM low valuation. And with management's goal of generating mid-single-digit revenue growth after the spinoff, IBM could be perceived as a growth stock, which would support a higher valuation.

Thus, given the company's modest stock price despite its increasing exposure to growth markets, I consider IBM stock as a buy and I plan to hold my shares while the company's transition is materializing.

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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