Shares of technology giant International Business Machines (IBM -1.05%) have bounced back from their pandemic-era lows, but the stock remains down about 21% from its all-time high reached more than a decade ago. The company has long been transforming itself for the age of cloud computing. Progress has been slow.
IBM now appears to be hitting its stride. The company has shed around 15 businesses in recent years, including the spinoff of its managed infrastructure services unit into Kyndryl. While the company has made plenty of acquisitions as well, notably the $34 billion purchase of Red Hat in 2019, these actions have shifted IBM's focus to its best growth opportunities and away from slow-growing legacy businesses.
Hybrid cloud and AI
The two biggest growth opportunities for IBM are hybrid cloud computing and artificial intelligence. The company is going after both through its software and consulting businesses.
Red Hat forms the foundation of IBM's hybrid cloud efforts. OpenShift, Red Hat's containerization platform, controlled nearly 50% of the container software market in 2020. Red Hat's software can run anywhere, including on competing public cloud platforms and on on-premises servers.
IBM's AI efforts are now being driven by Watsonx, a new AI platform that enables enterprises to deploy AI models while handling regulatory and data privacy concerns. Like its hybrid cloud platform, Watsonx isn't tied to IBM's own cloud. A portion of the AI platform is already available through Amazon Web Services.
Tying all this together is IBM's consulting business, which provides guidance and crafts solutions for clients. IBM wins by delivering the best solutions possible for its clients, and that often involves products from other technology companies. A slew of strategic partnerships struck in the past couple of years, including one with AWS that brought IBM's software to the leading cloud platform, allows the consulting arm to mix IBM products more easily with products from partners.
A reasonable valuation and a nice dividend
By embracing the platforms and products that its clients want to use, IBM has rekindled its growth. Revenue is expected to grow by 3% to 5% this year excluding the impact of currency, a solid result compared to IBM's performance in recent years. A full 75% of IBM's revenue now comes from software and consulting, and about half of total revenue is recurring in nature.
IBM's bottom line is also improving thanks to the high-margin nature of its growing software business. While revenue expanded by just 3% in the third quarter, gross profit jumped 8%, pretax income rose 17%, and earnings per share soared 22%. Free cash flow also improved, and the company is on track to deliver free cash flow of $10.5 billion this year. That's up more than $1 billion from 2022.
IBM stock has rallied about 15% this year, pushing its market capitalization up to roughly $149 billion. Based on the company's guidance, the stock trades for about 14 times free cash flow. While IBM's revenue won't grow much faster than the mid-single-digit percentage the company is targeting as part of the mid-term model it rolled out in 2021, free cash flow can grow faster as margins improve. If IBM can keep growing free cash flow at a high single-digit rate annually, at least on average, the valuation looks reasonable.
That free cash flow fuels the company's dividend, which it has paid uninterrupted since 1916. The dividend has been increased annually for 28 years in a row. The current quarterly dividend of $1.66 per share works out to a dividend yield of about 4.1%. Dividend growth has been slow since the pandemic, but it could pick back up as free cash flow expands.
It's been a long road for IBM over the past decade as the century-old company rejiggered itself for a cloud-first, AI-heavy world. The hard part now appears to be over, as IBM's portfolio of products and services is aligned with these two growth opportunities. If IBM can maintain its revenue and free cash flow growth, it won't be long before it starts carving out new all-time highs for the first time in more than a decade.
