Investors reacted negatively to the second-quarter earnings report from International Business Machines (IBM 1.25%). While revenue and cash flows continue to improve, investors balked as cash flows failed to meet expectations.
However, such challenges do not change the fact that its transformation continues to succeed. Amid some minor uncertainty, the latest decline looks like an opportunity to buy into this cloud stock at a lower price.
IBM can't get a break
IBM received yet another reminder that the market is an expectations game. Like many stocks, rising wage inflation and the rising dollar put pressure on its gross profit margins. These margins fell to 53% for the first half of 2022 versus 54% in the first six months of 2021.
Investors also balked as IBM said it would generate $10 billion in free cash flow for 2022. It forecasted in past quarters that it would produce $35 billion in free cash flow in the 2022 to 2024 time period. Since that would imply $11.67 billion in free cash flow for the year, $10 billion is a relative disappointment.
Also, with the post-earnings drop, IBM stock has lost close to 30% of its value over the last 10 years. That represents a good deal of frustration for long-term shareholders and could imply a low tolerance for any disappointment.
And to be sure, its $34 billion purchase of Red Hat was a huge gamble that has left the company with more than $50 billion in debt three years after closing the deal. Considering its $19 billion in stockholders' equity, it continues to produce considerable strain on the balance sheet.
The case for looking past the negatives
Nonetheless, IBM has improved its finances since it closed the Red Hat deal in July 2019. Following that quarter, total debt stood at almost $62 billion. Even though its total debt is still considerable, IBM has steadily reduced it.
Moreover, investors should note that IBM reiterated its forecast of $35 billion in free cash flow for the 2022 to 2024 period on the Q2 2022 earnings call. Given its revenue and earnings growth, that longer-term goal is achievable even if it does not beat the 2022 forecast for $10 billion in free cash flow.
These cash flows also leave its dividend intact. The payout, now at an annual $6.60 per share, yields a cash return of 5% and is on track to claim $6 billion of its free cash flow this year. Also, as its 27 annual payout hikes give it Dividend Aristocrat status, the increases will probably continue.
Other financial metrics point to progress
Additionally, IBM's transformation shows signs of success. In the first two full quarters after the Kyndryl spin-off, revenue of almost $30 billion came in 8% higher than the same period in 2021. That amounts to a vast improvement over the first half of 2021 when revenue growth came in at 2% versus the same period in 2020.
Also, the hybrid cloud segment reported a 16% revenue gain over the previous 12 months. This shows that IBM's efforts to redefine itself as a cloud company continue to pay off for the tech giant.
Moreover, it made considerable improvements in income from operations. This figure came in at $2.1 billion for the first half of 2022, a 75% increase from the same timeframe in 2021, though the separation costs associated with the Kyndryl spinoff in 2021 contributed significantly to this growth rate.
Furthermore, even after the decline, IBM stock continues to outperform the S&P 500 over the last year. And while its P/E ratio of 21 has climbed since the height of the pandemic, it is much cheaper than the top two cloud companies. Currently, Amazon and Microsoft sell for 57 times and 27 times earnings, respectively.
IBM is on the right track
The drop in IBM stock seems unjustified and looks like an excellent opportunity to add shares. Indeed, smaller gross profit margins and lower free cash flow may lag expectations right now, and its legacy of stock declines and debt may continue to burden the company.
However, its hybrid cloud growth and overall revenue increases should relieve these burdens over time. Assuming IBM stays on its current track, the company and its stock should prosper long term.