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IBM Has a Lot to Prove in 2021

By Timothy Green - Jan 26, 2021 at 7:30AM

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A return to growth won't be enough on its own to change the narrative.

Many tech stocks have soared as markets recovered from the pandemic-driven sell-off early last year. IBM (IBM 1.07%) is an exception. The century-old tech giant was already disliked by investors before the pandemic as it slogged through a multiyear turnaround; the company's results have deteriorated since, as customers pull back on spending amid unprecedented uncertainty.

IBM's fourth-quarter report last week sent the stock down around 10% on Friday, erasing the gains logged so far this year. While there were some green shoots in IBM's results, it's clear that the company has a lot of work to do to win over investors this year.

A cloud.

Image source: Getty Images.

Tumbling revenue and profit

IBM's total revenue for the fourth quarter sank 6% to $20.4 billion; it was down 8% adjusting for divested businesses and currency. All of IBM's segments struggled. The cloud and cognitive software segment, which houses some of IBM's key cloud and artificial intelligence (AI) products, suffered a 7% sales decline. That was entirely due to a 26% plunge in sales of transaction processing products.

The services businesses fared no better. Global business services sales were down 5%, while global technology services sales were down 8%. "Our performance reflects the fact that our clients continue to deal with the effects of the pandemic and broader uncertainty of the macro environment," said CEO Arvind Krishna during the earnings call.

The bottom line took a big dive thanks to lower revenue and a large restructuring charge. Adjusted earnings per share tumbled 56% to $2.07.

A return to growth this year

It wasn't all bad news for IBM. Total cloud revenue grew by 10% during the quarter to $7.5 billion, pushing cloud revenue for the full year up to $25.1 billion. Red Hat also performed well, with normalized revenue soaring 19% from the prior-year period. The debt from the Red Hat acquisition is being quickly brought down, with IBM reducing its total debt load by $3.9 billion in the fourth quarter alone.

IBM expects to produce revenue growth in 2021 as spending from clients recovers, and as the company's hybrid cloud and artificial intelligence initiatives take hold. IBM also expects to produce between $11 billion and $12 billion of free cash flow for the year, excluding cash spending related to restructuring and the planned spinoff of the managed infrastructure services business. The company logged $10.8 billion of free cash flow for 2020.

Krishna explained in the earnings call: "In 2021, the significant changes we have made to focus on hybrid cloud and AI will also begin to take hold. The company will look different at the end of the year, particularly with the execution of the spinout, but also with the operational changes to sharpen our focus."

Time is not on IBM's side

IBM has been transforming itself for the better part of a decade at this point. A return to sustainable growth has proved elusive. The acquisition of Red Hat in 2019 and the managed infrastructure services spinoff are the two biggest moves the company has made so far, and IBM is undoubtedly a leader in the hybrid cloud market that it sees as a $1 trillion opportunity. But there's been little in the way of improved financial results, which is what the market cares about.

Revenue growth this year isn't going to be enough on its own to convince investors that the IBM turnaround story is worth investing in. The bar is low: Revenue slumped 5% in 2020 as the pandemic raged. IBM needs to convince investors that its return to growth is for real this time, driven by its bets on hybrid cloud computing, artificial intelligence, blockchain, and other growth areas. Another temporary return to growth isn't going to cut it.

For patient investors who believe in IBM's strategy, the stock has a lot to offer. It now trades for just 9.5 times the low end of the company's free cash flow guidance for 2021, and it sports a dividend yield of 5.5%. There's a strong value case to be made for IBM; whether it works out for investors in the long run depends on the company's all-in bet on hybrid cloud computing paying off.

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