International Business Machines (IBM -1.05%) has spent the better part of the past decade repositioning itself for the era of cloud computing and artificial intelligence. The $2 billion acquisition of SoftLayer in 2013 kick-started the company's cloud business, and the $34 billion acquisition of Red Hat in 2019 was a bet that enterprises would gravitate toward multi-cloud and hybrid cloud deployments.
IBM has shed plenty of underperforming businesses as well. The company unloaded its semiconductor manufacturing operation and its x86 server operations back in 2014, spun-off its managed infrastructure services business in 2021, dumped its Watson Health business in 2022, and largely gave up on its enterprise blockchain efforts earlier this year. The IBM of today is leaner and more focused than the IBM of a decade ago.
While IBM stock is still stuck in the doldrums, one analyst sees happier days ahead for shareholders. Matthew Swanson of RBC Capital started IBM with an "outperform" rating last week and attached a $188 price target. That's the highest price target among Wall Street analysts.
That price target represents an upside of nearly 30% from the current stock price. While IBM stock could do anything in the short term, Swanson's target certainly doesn't look far-fetched given IBM's valuation and growth prospects.
Underappreciated businesses
Following IBM's spin-off of its managed infrastructure services business, the company's two largest segments are software and consulting. The software business generated $6.6 billion of revenue in the second quarter and grew by 8% at constant currency, while the consulting business generated $5 billion of revenue and grew by 6%. Together, these segments accounted for about three-quarters of IBM's total revenue.
Swanson believes these two segments are not being fully appreciated by investors as IT environments become more complex. For large organizations with sprawling IT infrastructures, modernization is not a simple matter of moving everything to a single public cloud. Mixing and matching multiple public clouds along with on-premises hardware requires software solutions as well as guidance and know-how. IBM's software business handles the former, while its consulting business handles the latter.
These businesses can help fuel each other. If IBM wins a consulting contract to help a client adopt a hybrid cloud architecture, it's likely that a portion of the solution is going to involve IBM software or hardware.
That won't always be the case, as one of the strengths of IBM's consulting arm is that won't hesitate to recommend non-IBM solutions. IBM has partnerships with Amazon Web Services, Oracle, SAP, and other direct competitors, and it leads customers to those competing solutions when it makes sense to do so.
Nonetheless, the explosion of complexity in IT environments is a tailwind for IBM. In addition to helping clients with hybrid cloud deployments, the company is aiming to be the partner of choice for enterprise AI. IBM's watsonx platform enables clients to train and deploy AI models while keeping transparency, privacy, and regulatory concerns in mind.
A dirt cheap stock
IBM expects to grow total revenue by 3% to 5% this year after adjusting for currency, a solid result given the macroeconomic backdrop. With software and consulting segments that are heavily focused on hybrid cloud and AI, the company's long-term growth prospects look solid.
Free cash flow should come in at around $10.5 billion this year, according to IBM's guidance. That puts the price-to-free-cash-flow ratio at less than 13. The high-margin software business can drive profit margins higher as time goes on, so IBM should be able to grow its free cash flow over time.
IBM also pays a sustainable dividend that yields about 4.5%. Dividend payments will eat up just over $6 billion over the next year, leaving plenty left over for acquisitions and debt reduction. The company has halted share buybacks as it works to pay down debt from the Red Hat deal, but buybacks could be restarted down the road.
IBM's valuation would still be reasonable if the stock were to rise nearly 30% to Swanson's price target, and it could still look cheap if the company grows its free cash flow in the years ahead. While IBM's turnaround is still a work in progress, the company has come a long way as it stakes a claim in the cloud computing and artificial intelligence markets.
