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3 Reasons to Buy IBM, and 1 Reason To Sell

By Leo Sun – Sep 8, 2021 at 11:28AM

Key Points

  • IBM has a new CEO and ambitious plans for the future.
  • Big Blue will split into two companies by the end of the year.
  • The stock's valuation is cheap, but the company's turnaround plans still face plenty of challenges.

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Is Big Blue dead money -- or a potential turnaround play?

Over the past ten years, IBM's (IBM -0.33%) stock declined nearly 20% as the S&P 500 rallied almost 280%. Even after factoring in reinvested dividends, IBM generated a total return of less than 20% as the S&P 500 produced a total return of more than 360%.

IBM struggled as its revenue growth stalled out. While many of its industry peers expanded their cloud ecosystems with aggressive investments and acquisitions, IBM cut costs and repurchased more shares to boost its earnings per share. IBM eventually tried to catch up with several big cloud acquisitions, but it couldn't expand those newer businesses rapidly enough to offset the stagnation of its older businesses.

A cutout of a blue cloud next to a laptop computer.

Image source: Getty Images.

That dismal track record suggests IBM's stock is dead money, but past performance is never a reliable indicator for future gains. So could IBM actually be a cheap contrarian play in this frothy market? Let's dig deeper into three reasons to buy Big Blue -- and one reason to sell it -- to decide.

1. A "new" IBM will emerge this year

IBM's cloud chief Arvind Krishna succeeded Ginni Rometty as the tech giant's CEO last April. In October, IBM announced it would spin off its slower-growth managed infrastructure services unit into a new company called Kyndryl. IBM expects the spin-off to conclude by the end of 2021.

The skeptics will claim IBM is simply moving the same old parts around, but IBM believes the spin-off will free up more resources to expand its higher-growth hybrid cloud and AI businesses. Meanwhile, Kyndryl can focus on expanding its own IT services without the burden of supporting IBM's cloud-based initiatives, which could widen its moat against higher-growth IT companies like Accenture.

Instead of going head-to-head against Amazon (AMZN -1.44%), Microsoft (MSFT 0.13%), and Alphabet's (GOOG -0.44%) (GOOGL -0.55%) Google in the crowded public cloud market, IBM plans to launch more services for hybrid clouds, which merge on-site private clouds with public cloud services.

IBM's hybrid cloud services, which are mainly powered by Red Hat's open-source software, process the data that flows between public and private clouds. The hybrid cloud is also a fertile market for launching AI tools, which can analyze that information to help businesses make data-driven decisions.

Krishna believes the hybrid cloud represents a "$1 trillion market opportunity" over the long term. If this expansion plan pays off, the "new" IBM could finally generate consistent revenue growth again. 

2. Focusing on growth instead of high dividends

IBM said the two streamlined companies will pay a "combined quarterly dividend that is no less than IBM's pre-spin dividend per share." However, that language suggests the "new" IBM could eventually reduce its dividend to free up more cash for its hybrid cloud investments. At the same time, Kyndryl might maintain a higher payout by returning most of its free cash flow (FCF) to investors via dividends and buybacks.

IBM would drop out of the Dividend Aristocrats next year if it ends its 26-year streak of annual dividend hikes, and its forward yield of 4.7% would likely decline. But it could also be a smart long-term move since IBM spent 40% of its FCF ($5.8 billion) on dividends over the past 12 months. That cash would arguably have been better spent on revenue-boosting investments.

3. IBM's stock is still cheap

IBM's stock trades at 12 times forward earnings, making it much cheaper than Amazon, Microsoft, and Alphabet. However, the bears will argue that its sluggish growth justifies that steep discount.

But if IBM's growth stabilizes and shows some signs of staging a Microsoft-like turnaround, it could command a much higher valuation. Meanwhile, IBM's low P/E ratio could limit its downside potential and make it an attractive safe-haven stock if the market crashes.

An engineer using a laptop computer in a server room.

Image source: Getty Images.

The one reason to sell IBM: Its cloud competitors

When Berkshire Hathaway sold all of its IBM shares three years ago, Warren Buffett expressed concerns about IBM's ability to stay competitive in the crowded cloud market.

Buffett's assessment is still right. IBM believes it can carve out a niche within the hybrid cloud market, but Amazon, Microsoft, and Google are all extending the reach of their public cloud platforms with hybrid cloud services that connect to private clouds. All three cloud giants also offer "virtual private cloud" deployments that combine the security of private clouds with the scalability of public clouds.

In other words, the hybrid cloud market could gradually be absorbed by the growing public cloud market -- and IBM's main growth market could disappear.

The bottom line

IBM is taking baby steps to turn around its business, but the process is slow and faces plenty of challenges. Investors who already own IBM should hold onto their shares and wait for the upcoming spin-off, but investors who don't own it yet should probably consider buying more promising tech stocks.

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool's board of directors. Leo Sun owns shares of Amazon. The Motley Fool owns shares of and recommends Accenture, Alphabet (A shares), Alphabet (C shares), Amazon, Berkshire Hathaway (B shares), and Microsoft. The Motley Fool recommends the following options: long January 2022 $1,920 calls on Amazon, long January 2023 $200 calls on Berkshire Hathaway (B shares), short January 2022 $1,940 calls on Amazon, short January 2023 $200 puts on Berkshire Hathaway (B shares), and short January 2023 $265 calls on Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.

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