Please ensure Javascript is enabled for purposes of website accessibility

Is IBM a Value Stock or a Value Trap?

By Leo Sun - Jan 27, 2021 at 9:15AM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Big Blue's long-awaited recovery still hasn't started.

IBM's (IBM -0.91%) stock price recently tumbled after the tech giant posted its fourth-quarter numbers. Its revenue dropped 6% year over year to $20.4 billion, missing estimates by $260 million and marking its fourth straight quarter of declining sales. Its adjusted earnings fell 56% to $2.07 per share, though it still beat expectations by $0.19.

IBM's results weren't surprising, since it's repeatedly struggled to offset the slow growth of its legacy IT services, on-site software, and hardware businesses with its newer cloud-based businesses. However, investors were also likely expecting better results after IBM acquired Red Hat in 2019 and brought in a new CEO last year.

IBM has already been a disappointing investment over the past 10 years. Its stock lost about a quarter of its value and reinvested dividends only gave investors a total return of 3% -- compared to a total return of nearly 270% for the S&P 500 over the same timeframe.

A disappointed investor takes a break from the trading screen.

Image source: Getty Images.

But despite that poor track record, the bulls still believe IBM is a value stock on the verge of a turnaround. IBM certainly looks cheap at 10 times forward earnings with a hefty forward dividend yield of 5.5% -- but is it a value stock, or a value trap?

What the bulls believe about IBM

The bulls believe three catalysts will end IBM's losing streak. First, they expect its total cloud revenue to continue rising as it expands its hybrid cloud and AI services.

Second, they expect Red Hat's open-source software -- which plugs into a wide range of private and public cloud platforms -- to strengthen its presence in hybrid cloud deployments. They believe Arvind Krishna, IBM's new CEO who previously led its cloud and cognitive software division, can lead that transformation.

Lastly, the bulls expect IBM's upcoming spin-off of its slower-growth managed IT services division, which should occur by the end of 2021, to free up more resources for its hybrid cloud and AI businesses. That split could also allow the IT services segment to expand as a stand-alone company that isn't burdened with supporting IBM's higher-growth cloud businesses.

What the bears will point out about IBM

Those strategies sound good on paper, but the bears will point out three flaws in IBM's plans. First, IBM's cloud growth is tepid. Its cloud and cognitive software revenue rose just 2% to $23.4 billion, or 32% of its top line, in fiscal 2020. This was the only core business segment that generated any sales growth during the year.

IBM claims its "total" cloud revenue, which includes cloud services from other segments, rose 19% to $25.1 billion. However, this metric is inflated by its acquisition of Red Hat, and obfuscated by opaque reporting methods for cloud services scattered across its legacy businesses. If you look at the growth of IBM's six core businesses in 2020, it's impossible to tell how its "total" cloud growth actually benefits the company:

Segment

FY 2020 Revenue

Growth

Cloud and Cognitive Software

$23.38 billion

2%

Global Business Services

$16.16 billion

(4%)

Global Technology Services

$25.81 billion

(6%)

Systems

$6.98 billion

(8%)

Global Financing

$1.12 billion

(20%)

Other

$169 million

(85%)

Total

$73.62 billion

(5%)

Source: IBM.

Moreover, IBM's entire cloud business is both smaller and growing at a slower rate than larger cloud platforms like Amazon (AMZN 0.25%) Web Services (AWS) and Microsoft's (MSFT -0.23%) Commercial Cloud.

Second, spinning off the managed IT services segment might not generate sustainable sales growth. Krishna believes IBM can wedge itself between private and public cloud platforms with hybrid cloud deployments, but Amazon, Microsoft, and other companies also offer similar services.

Lastly, Krishna blamed the company's fourth-quarter sales decline on the pandemic and macro headwinds, which applied "additional pressure on larger software transactions" and caused "project delays in some services engagements."

But we've heard these reasons before, and they don't explain why other software companies -- including Amazon, Microsoft, and high-growth darlings like Snowflake -- remained resilient through the downturn. Even Oracle, which is undergoing a similar cloud-based transformation as IBM, generated stronger growth.

That glaring gap indicates that enterprise customers didn't necessarily spend less money during the pandemic -- they just spent less money on IBM's services.

It's still a value trap -- for now

Krishna believes the "new" IBM will generate "sustainable mid-single-digit" percentage revenue growth after it completes its separation, led by the expansion of Red Hat (which generated 18% sales growth during 2020), improvements to its global business services (GBS) segment, and the integration of new hybrid cloud and AI services into its GBS ecosystem.

That outlook sounds promising, but Krishna also warned that IBM's recovery was "not necessarily going to be a straight line." In other words, investors should still expect weak sales growth, opaque reporting methods for its cloud business, and ugly comparisons to its industry peers for the foreseeable future.

IBM isn't doomed yet. But in a market filled with higher-growth cloud and software plays, IBM definitely looks like a value trap instead of a value stock.

 

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

International Business Machines Corporation Stock Quote
International Business Machines Corporation
IBM
$128.48 (-0.91%) $-1.18
Microsoft Corporation Stock Quote
Microsoft Corporation
MSFT
$252.56 (-0.23%) $0.58
Amazon.com, Inc. Stock Quote
Amazon.com, Inc.
AMZN
$2,151.82 (0.25%) $5.44

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning service.

Stock Advisor Returns
330%
 
S&P 500 Returns
115%

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 05/22/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.