IBM (IBM 2.71%) stock has substantially lagged the broader market over the past several years, Big Blue has been basically flat since 2011, while the S&P 500 Index gained over 50% in the same period. On the other hand, this situation could be about to change, at least according to the analysts at independent research firm Argus.
Argus recently published a new report on IBM, upgrading the company from "hold" to "buy" with a target price of $175 per share. This change implies a big upside potential of nearly 20% from current price levels, not bad at all coming from a big and stable corporation.
Basically, two main ideas sustain the bullish thesis on IBM: Argus believes that financial performance could materially improve in the middle term, and the research firm also calculates that IBM stock is substantially undervalued at current prices.
Uninspiring performance
One of the main reasons IBM stock has stagnated over the past few years is disappointing revenue trends. Management is moving away from commoditized and hardware-related businesses to better focus on areas with superior growth prospects and more room for differentiation and profitability. As the company disposes of its less compelling assets, it's taking a toll on overall revenue growth.
In addition, it takes time to adapt to new industry trends. Cloud computing is hurting demand for IBM's servers and related software business, and the middleware and systems-management markets are going through considerable changes because of the rise of software-as-a-service.
In this context, revenues are under heavy pressure, and total sales declined 13% year over year during the last quarter. However, it's important to note that much of this decline was due to currency headwinds and divested businesses, since sales adjusted for these factors fell by a much more moderate 1%.
Potential for acceleration
On the other hand, earnings quality is improving as the company continues disposing of its lagging business segments. Comparisons are getting easier over time. Importantly, IBM is making big bets on a series of business areas it has identified as strategic imperatives, including cloud computing, data analytics, mobile, social, and security, among others.
The company is doing quite well in these segments. The strategic-imperatives group of businesses grew by 30% year over year during the last quarter when excluding foreign currency fluctuations and divested businesses. Cloud computing was especially strong, with an annual increase in adjusted revenue of over 70%, and reaching $8.7 billion in revenue over the 12-month period ended in June.
According to management, IBM is beating the competition in strategic imperatives by leveraging its deep connections and industry-specific know-how. In the words of SVP and Chief Financial Officer Martin Schroeter, "As we've said before, we are able to grow at a rate significantly faster than the market because of the industry perspective and deep insight we have from working with our clients on their core businesses to help move them to the strategic areas."
The company is now making nearly 30% of total revenue from strategic imperatives. These businesses will most likely account for a growing share of sales over the years, and this situation should have a material positive impact on overall revenue growth.
Attractive valuation
IBM stock is trading at compelling valuation levels. IBM carries a price-to-earnings ratio of around 12.6 earnings over the past year, a significant discount versus the average valuation for companies in the S&P 500, with a P/E ratio in the neighborhood of 18.5.
Dividends look quite attractive, too. IBM stock pays a dividend yield of 3.6% at current prices, and the company has a rock-solid track record of dividend growth over the years. IBM has paid uninterrupted dividends since 1916, and it has increased payments for 20 years in a row. Dividends have grown by a double-digit percentage rate for the past 12 years, and payments have doubled in the past five years. The latest dividend increase was a big 18% for 2015.
In addition, the company has an active share-buyback policy, IBM has repurchased more than 40% of the shares outstanding over the past decade.
Can IBM rise by 20%?
Price fluctuations are hard to predict, since they depend on a multiplicity of factors, related not only to the company in particular but also to general market conditions. Nevertheless, the main thesis from Argus seems quite well grounded, there is a considerable chance that sales performance can improve over the middle term, and IBM stock is conveniently valued.
