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Why Investors Should Not Lose Patience With IBM Stock

By Will Healy – Oct 22, 2020 at 9:50AM

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In time, the cloud should drive overall growth for the venerable tech giant.

International Business Machines (IBM 0.94%) reported its third consecutive quarter of declining revenue when it announced earnings on Monday. This took investor optimism out of the clouds, and IBM stock sold off by about 6%.

Indeed, IBM has faced falling revenue amid stagnation with some of its legacy businesses. The effects of COVID-19 have exacerbated the declines.

Nonetheless, IBM is remaking itself into a cloud company. With a little patience, the post-earnings sell-off in this tech stock could offer investors the chance to buy this cloud growth at an even deeper discount.

Clouds behind an "upload data to the cloud" icon.

Image source: Getty Images.

Investor frustration runs deep

The investor frustration is understandable. The company has made strides in capitalizing on the $1 trillion market opportunity in the hybrid cloud. It continues to make acquisitions such as Spanugo and WDG Automation to enhance its offerings. It has also brought on 47 companies in the Fortune 50 as clients.

ReportLinker estimates the hybrid cloud will grow at a compound annual growth rate of 20% through 2024. Hence, the company has positioned itself well for prosperity in this industry.

However, for all of this promise, the company continues to report falling revenue, as a 2.6% drop in overall revenue year over year overshadowed the 19% growth in cloud revenue.

The company has addressed this by spinning off the managed infrastructure services business, a portion of the global technology services division, into a separate company. Additionally, IBM will take a $2.3 billion structural charge to operating income in the fourth quarter. This is partially to help give both IBM and the new company investment-grade balance sheets. Though CEO Arvind Krishna and CFO Jim Kavanaugh put a positive spin on the situation, it did not dissuade investors from selling the stock.

Still, the new company, dubbed "NewCo" for now, will not separate for another year. The post-earnings sell-off may indicate investors may not want to wait that long.

Why investors should consider waiting for a recovery

When the spinoff occurs, IBM shareholders will receive shares of NewCo. NewCo's long-term future is a separate discussion. Nonetheless, its current revenue declines will no longer hold back IBM's potential, something cloud-focused investors will probably view favorably.

Although some non-cloud businesses will remain, the move will make the new IBM primarily a cloud company. Investors should also remember that Krishna previously headed IBM's cloud and cognitive software division. Moreover, since he was the driving force behind the $34 billion acquisition of Red Hat, his transition to the role may have begun well before he took the top job in April.

Additionally, the silver lining of IBM's situation is that investors can buy the stock cheaply. IBM trades at a forward price-to-earnings (P/E) ratio of about 10. After the spinoff, management also anticipates revenue growth in the mid-single-digits. Such increases could make the current valuation appear inexpensive.

Investors should also note the history of cloud peer Microsoft. It traded at a single-digit forward P/E ratio before its cloud head, Satya Nadella, became CEO. Microsoft's cloud transformation has helped to take that forward multiple to about 33 today. If Krishna can repeat this feat with IBM's hybrid cloud niche, shareholders could benefit from a similar multiple expansion.

Furthermore, IBM's current dividend of $6.52 per share now yields 5.5%. The 25 consecutive years of dividend increases make it a Dividend Aristocrat. IBM has not yet revealed how much of that payout will go to NewCo. However, both companies will remain Dividend Aristocrats should they continue the annual payout hikes.

IBM's short-term outlook remains lackluster. Investors have lost patience with the company as falling revenue and earnings obscured the gains in the cloud.

Nonetheless, this path has given a new lease on life to a stagnant legacy tech company. For investors willing to have patience and collect a generous payout while they wait, buying IBM amid this sell-off could also pay dividends of a different kind.

Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool's board of directors. Will Healy owns shares of IBM. The Motley Fool owns shares of and recommends Microsoft and recommends the following options: short January 2021 $115 calls on Microsoft and long January 2021 $85 calls on Microsoft. The Motley Fool has a disclosure policy.

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