International Business Machines' (IBM -0.69%) has focused more on its growth businesses, such as cloud computing and artificial intelligence (AI), in recent years. Yet, that focus adjustment has yet to translate into strong quarterly results. During the tech giant's fourth-quarter earnings call last week, management again expressed confidence in increasing revenue and free cash flow over the next two years. Stock trading on the day earnings were released though suggests the market is skeptical.
Considering the company's current low valuation and the challenging transformation it has set for itself, is IBM stock a buy?
Yet another challenging quarter
Over the last several years, Big Blue has been struggling to offset the decline of its large legacy business segments (on-premises software, hardware, and services for enterprises).
The fourth quarter was no exception. Adjusted for divestitures and at constant currency, revenue declined 8% year over year to $20.4 billion. During the earnings call, CEO Arvind Krishna justified this underwhelming performance with customers delaying projects and signing shorter service engagements amid economic uncertainty. In addition, the planned spinoff of IBM's legacy consultancy activities led to longer negotiations that postponed some deals.
The company's cloud businesses kept generating solid results, though. For instance, the cloud specialist Red Hat, acquired by IBM in 2019 for $34 billion, grew 18% year over year on a normalized basis in 2020. And the number of customers that use IBM's hybrid cloud platform, which allows applications to run on private and public clouds, increased by 40% year over year to 2,800.
More generally, revenue from cloud increased 8% year over year (at constant currency) to $7.5 billion and represented 37% of total revenue during the fourth quarter, up from 31% of the total in the prior-year period.
A brighter future thanks to hybrid clouds
As a growing part of IBM's revenue, cloud activities should increasingly contribute to the company's top-line performance. And management has been investing to fuel that growth thanks to the company's strong free cash flow of $10.8 billion over the last 12 months.
As an illustration, since Krishna took over in April 2020, the company announced 10 acquisitions to strengthen its hybrid cloud and AI portfolio and services. For instance, Red Hat signed a definitive agreement at the beginning of the year to acquire the security specialist StackRox and enhance its flagship hybrid cloud platform OpenShift with cloud-native security capabilities.
Investments in the hybrid cloud area have become key to IBM's transformation. Indeed, management estimates the hybrid cloud market at $1 trillion, and with relevant acquisitions and internal developments, IBM can leverage and enhance its software and services offerings to address that significant opportunity (fewer than 25% of workloads have been moved to the cloud so far).
Strong execution should lead to improving performance by the second half of the year. And with operating leverage, increasing free cash flow should fund the company's ambitions in investing in hybrid cloud and AI opportunities, sustaining its dividend, and reducing its debt load.
So management expects adjusted free cash flow to reach between $11 billion and $12 billion in 2021, and between $12 billion and $13 billion in 2022. Adjusted free cash flow over the next two years will depend on the timing of cash tax items, and it excludes reorganization expenses. But if you consider $11 billion of annual free cash flow going forward, IBM stock looks cheap at less than 10 times that estimated free cash flow.
Granted, besides the operational risks, the reorganization of the company, which includes the spinoff of its legacy consulting business and the simplification of its go-to-market model, will lead to significant exceptional expenses of approximately $4 billion over the next 18 months.
Yet investors should consider IBM as an attractive tech stock. In contrast to some high-growth tech specialists, the company won't generate spectacular results over the next few years, but its valuation corresponds to low expectations -- no growth -- despite increasing exposure to the promising hybrid cloud and AI markets.