Following the spinoff of its managed infrastructure services business, which removed around $19 billion of less-than-desirable revenue from the income statement, International Business Machines (IBM 0.16%) is a leaner and more focused company. Hybrid cloud, artificial intelligence, high-margin software, and consulting are the businesses that will drive revenue and profit growth in the coming years.
IBM's fourth-quarter results offered a demonstration of what the "new IBM" looks like. Total revenue was up 6% adjusted for currency, with over 70% of that revenue coming from software and consulting. Pre-tax profit margin expanded by 1.7 percentage points, driven by growth and margin expansion in the software and consulting segments. Revenue from Red Hat, which forms the foundation of the company's hybrid cloud platform, jumped by 15%.
Growing free cash flow
Revenue growth and improvements in margins are always good, but cash flow is how IBM funds its dividend, reduces its debt, pays for acquisitions, and makes capital investments. On that front, IBM's results and outlook were impressive. The company generated $9.3 billion of free cash flow in 2022, an improvement of $2.8 billion over 2021.
In 2023, IBM expects to grow free cash flow to approximately $10.5 billion, a $1.2 billion improvement over 2022. That growth will come from higher revenue, higher margins, and working-capital efficiencies. The company is currently working against the negative impact of currency exchange rates. Since IBM reports in U.S. dollars but has operations around the world that do business in different currencies, a strong dollar can negatively affect both revenue and free cash flow.
While IBM's free cash flow is on the rise, the company appears likely to fall short of the multiyear target it set in 2021. During the company's Investor Day event that year, it laid out a goal of generating cumulative free cash flow of $35 billion in the three-year period ending in 2024. Given results from 2022 and guidance for 2023, 2024 would need to be a bumper year for IBM to hit that target.
CFO Jim Kavanaugh didn't reiterate or rule out hitting that target on the earnings call, but he laid out some things that had changed. For one, IBM exited Russia last year due to the war in Ukraine, which caused the loss of a profitable business. Second, the U.S. dollar ended up appreciating far more than the company was expecting. Both of these issues will make it much more difficult for IBM to grow free cash flow enough to reach that target.
A bargain value stock
While IBM's free cash flow probably won't look quite as impressive through 2024 as the company expected it to look back in 2021, growing free cash flow significantly as the economic environment worsens is an accomplishment.
IBM is currently valued at roughly $120 billion. Based on 2023 guidance, the stock trades for less than 12 times free cash flow. Given IBM's much-improved growth profile following the spinoff, that seems overly pessimistic.
IBM's transformation has taken the better part of a decade, but the company now appears capable of growing revenue sustainably. As IBM builds a track record, that valuation multiple has plenty of room to expand in the years ahead.
