Analysts more or less knew International Business Machines (IBM 1.09%) was going to post lackluster fourth-quarter numbers. But they underestimated just how tough things were during the three-month stretch ending in December.
Revenue not only fell 6% year over year, to $20.4 billion, but it fell short of the consensus estimate of $20.7 billion. Earnings, at $2.07 per share, technically topped expectations of $1.79, but it's a dubious win. Profits were still down from the year-earlier figure of $4.71 per share. Despite the company's relatively rosy outlook for the year now underway, the market saw the glass as half-empty. IBM stock took a 10% tumble, moving back within reach of multiyear lows reached in March of last year.
This sell-off is ultimately a buying opportunity, however, for investors willing to look more than a few weeks ahead. Not only is IBM now on the right path, but investors are being paid a fat dividend while waiting for IBM's regrouping plans to pan out.
An overhaul is ahead for IBM
The regrouping in question is the intended divestiture laid out in October. International Business Machines aims to shed its managed infrastructure services arm before the end of the year so it can focus on cloud software (and hybrid cloud in particular) solutions. The spinoff will shed around $19 billion worth of yearly business. But it will leave the somewhat smaller IBM with more growth potential.
Relatively new CEO Arvind Krishna put things in perspective in October, explaining that hybrid cloud computing is a $1 trillion opportunity. He added during last week's earnings conference call that the "significant changes we have made to focus on hybrid cloud and AI will also begin to take hold [in 2021] ... with better performance in the second half than the first half." Following the spinoff, he's looking for regular "mid-single-digit revenue growth," supported by the fact that only around 25% of enterprises have migrated to cloud computing solutions thus far.
Still, the plans leave investors in something of a lurch. We know IBM's Global Technology Services division that currently houses the company's managed infrastructure unit produces on the order of $10 billion worth of EBITDA per year, or roughly one-fourth of the company's total annual EBITDA. We just don't know exactly how much of that money is attributable to the managed infrastructure arm that's going away. It's also tough to trust IBM's optimism in the shadow of a renewed revenue and income headwind that materialized in 2018, well before the COVID-19 pandemic did.
However, those unknowns and uncertainties become somewhat irrelevant at the stock's current valuation. Shares are priced at only 10.9 times this year's expected profits and only 9.9 next year's projected earnings -- earnings which remain more than adequate to cover the current quarterly dividend payout of $1.63 a share, resulting in a 5.5% yield. And, no matter how revenue and earnings are divvied up by the spinoff, this company is still a beefy cash cow expected to hammer out a little fiscal progress going forward. The graphic below puts things in perspective.
The unseen clincher for IBM's stock
So if International Business Machines is headed for better days, why isn't this reflected by a frothier valuation?
One partial explanation is doubt. IBM is a habitual underperformer. Perhaps the bigger reason its shares remain so easily undermined, though, is a misunderstanding of the technology market's unique cycles leading to recent subpar results.
CFO Jim Kavanaugh arguably articulated it best during last week's earnings call, explaining the company's software shortfall:
On average, those are about three-year cycles. We had the peak cycle in 4Q '19. We grew software revenue 10% off of that. And underpinning that, the transactional volume in that software was up close to 30% overall. So we were in a trough year. We knew fourth quarter was going to be the most challenging quarter all year long.
While he was speaking of the company's software business, bear in mind software helps drive hardware and service business, and vice versa.
Whatever the timing, the cyclical headwind appears on the verge of reversing. Kavanaugh went on to say that the company is "capitalizing on [the migration to cloud computing]. We got a $25 billion cloud base of business that's growing 20%. And we've got continued acceleration in our hybrid cloud platform with very good performance in Red Hat," echoing comments made by Arvind Krishna during the call.
There's still risk in owning IBM, to be sure, but not as much as some fear. And it's being paired with more potential upside than most investors are seeing. Time should solve both problems. Investors are collecting a nice 5.5% dividend while they wait.