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Better Buy: IBM vs. Alphabet

By Leo Sun - Feb 18, 2021 at 7:45AM

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Which tech giant will generate bigger gains this year?

IBM (IBM -0.91%) and Alphabet (GOOG -1.29%) (GOOGL -1.34%), the parent company of Google, have generated very different returns for investors over the past 12 months. IBM's stock price sank about 20% as it struggled to grow its revenue, while Alphabet's stock price rallied nearly 40% as its core businesses remained resilient throughout the pandemic.

I compared these two tech giants nearly a year ago and told investors to bet on Alphabet's strengths instead of IBM's speculative turnaround. But with a new CEO leading a fresh push to expand its stronger businesses and jettison its weaker ones, will IBM outperform Alphabet this year?

An illustration of cloud computing connections.

Image source: Getty Images.

Why did the bulls favor Alphabet over IBM?

Alphabet generated 80% of its revenue from Google's ads in 2020. Its ad sales decelerated throughout the pandemic, but stabilized in the second half and still grew 9% for the full year.

The resilience of that core business, along with its 46% growth in Google Cloud revenue, lifted Alphabet's revenue and earnings 13% and 19%, respectively, for the full year. Its operating margin also rose from 21% to 23% as it reined in its spending throughout the pandemic.

IBM's revenue has declined year over year over the past four quarters, and its revenue and adjusted earnings dropped 5% and 32%, respectively, in 2020. Its gross margin improved slightly, but its pre-tax margin from continuing operations still plunged from 13.2% to 6.3%.

IBM struggled as the weakness of its legacy IT services, on-site software, and hardware segments offset the rising revenue at its cloud business, which grew 19% during the year and accounted for over a third of its top line. IBM claims many clients postponed big deals throughout the crisis, which largely offset its integration of Red Hat's faster-growing business over the past year.

Both companies will face challenges this year

Analysts expect Alphabet's revenue and earnings to rise 24% and 19%, respectively, this year, as its ad sales accelerate after the pandemic ends. However, it still faces three unpredictable headwinds.

First, it faces ongoing antitrust challenges in the U.S. and Europe, which could result in fines or fresh restrictions on its core search engine and advertising businesses. Second, Apple's upcoming update for iOS 14, which will let users opt out of data tracking within apps, could throttle its growth in targeted ads.

Lastly, Google Cloud remains an underdog in the cloud infrastructure market, and it may need to sacrifice its margins to gain meaningful ground against Amazon and Microsoft. Those challenges could all weigh Alphabet's stock down, and explain why it still looks reasonably valued at 26 times forward earnings.

Two IT professionals walk through a data center.

Image source: Getty Images.

Analysts expect IBM's revenue to rise less than 1% this year as its legacy businesses face easier year-over-year comparisons, and for its earnings to grow 27%. But looking ahead, all eyes remain on IBM's upcoming split into two companies, which is expected to occur by the end of 2021.

That split, which was engineered by IBM's new CEO Arvind Krishna, would spin off the company's slow-growth managed IT services segment into a new company. Meanwhile, the slimmed-down IBM would allocate more of its cash and resources toward the expansion of its higher-growth hybrid cloud and AI businesses.

IBM's investors would get shares of both companies, and the "new" IBM could finally grow again by offering hybrid services that sit between private and public clouds -- but Amazon and Microsoft have also been gradually expanding their public cloud services into the hybrid market.

Those uncertainties are keeping investors away from IBM, which trades at just 10 times forward earnings while paying a high forward yield of 5.4%. Alphabet doesn't pay a dividend.

The obvious winner: Alphabet

Alphabet faces short-term challenges, but its big advertising business, market-leading search engine, and other services all make it a sound long-term investment trading at reasonable valuations.

IBM's near-term growth should remain weak, and it still hasn't revealed enough details about its post-split plans to justify a vote of confidence yet. Its low valuation and high yield may limit its downside potential, but it probably won't outperform Alphabet or the broader market until it proves its turnaround plans will actually work.

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Stocks Mentioned

Alphabet Inc. Stock Quote
Alphabet Inc.
GOOGL
$2,178.16 (-1.34%) $-29.52
International Business Machines Corporation Stock Quote
International Business Machines Corporation
IBM
$128.48 (-0.91%) $-1.18
Alphabet Inc. Stock Quote
Alphabet Inc.
GOOG
$2,186.26 (-1.29%) $-28.65

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

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