Growth Stocks: IBM

IBM (IBM.US) needs no introduction, but just in case, it's a storied technology company known for pioneering large mainframe computing systems. But that was before, now this business is marginal and was replaced by the personal computer (PC) revolution and with the support of Microsoft it managed to “dress” its terminals before launching them towards success.

In recent years, IBM has focused on its new business as a "platform" that focuses on hybrid cloud and Artificial Intelligence (AI) as its powerhouse. Both are high-growth markets with hybrid cloud forecast to grow at a rapid CAGR (compound annual growth rate) of 21.06% through 2026. Additionally, approximately 77% of IT decision makers have announced plans to use a "hybrid cloud," according to a study cited by IBM. There are also other studies outside of IBM that support this industry trend. AI is hot (you can download our AI report HERE) and the industry is estimated to grow at a CAGR of 37.3%, through 2030. To see where IBM stands, let's look at IBM's latest quarterly report, as well as its AI enablers and hybrid cloud.

Before we start, let's look at the IBM Chart

IBM.US, D1, Source: xStation

IBM's share price performance remains in a sideways range, retaining the main 2020 support and the main resistance zone in 2018 benchmark prices. This tells us that while IBM's pre-covid performance has not been so extraordinary that other technology companies, its resilience after the pandemic shows us the strength of the company and most importantly, that it continues to be a value to take into account right now that the AI sector is the most perceived by users and investors .

In the shorter term, the falling wedge structure (blue) maintains the bullish context, coinciding with price compression in the 61.8% area of the main fibo structure. This projects the potential for IBM stock to recapture 2018 prices at $152.95 per share.

After the technical analysis, fundamentals. Solid finances.

IBM delivered strong financial results for the fourth quarter of 2022. Revenue was $16.7 billion, exceeding analyst expectations by $313.39 million and virtually unchanged from the same quarter last year. This may not seem surprising, but looking back, at constant currency, revenue was up 6% year-on-year. For a mature, established company founded in 1911, this is not bad, especially since the company has reported negative growth rates between -4% in 2013 and -27.56% in 2019. Furthermore, IBM is currently in a business model transition process. On an earnings per share (EPS) basis, the company posted $2.96, up more than 15% year-over-year, beating analyst estimates by $0.22 per share, up 7.2%.

Estimated and estimated net income for 2023. Data by YCharts for Seekingalpha

Hybrid Cloud Tailwinds

The graph below shows that IBM has approximately 3% of the cloud infrastructure market. This may not sound like a huge stake, but considering that this market is estimated to grow at a CAGR of 19.9% and is expected to be worth over $1.7 billion by 2029. It is not nothing bad.

IBM market share (Statista, Synergy Research)

IBM has become a niche provider of hybrid cloud infrastructure. A "hybrid cloud" basically refers to the use of multiple cloud providers (AWS, Microsoft Azure, and Google Cloud) or one cloud provider with an IT system (offered by IBM) "in place". Companies that hire this service are adopting this methodology for a variety of reasons. First, using multiple cloud providers mitigates the "lock in" that a cloud provider will have on your infrastructure, which has been a concern for many organizations. Second, the use of multiple cloud providers allowed the specific benefits of each to be realized. For example, AWS likely has the most cost-effective infrastructure due to its scale. Whereas Microsoft Azure has quickly become a leader in artificial intelligence (AI) and plans to build one of the most powerful supercomputers in the world. IBM is also a strong player in this industry and its Summit Supercomputer was ranked #5 and #6 on the list of the 500 Greatest Supercomputers. Many organizations also use a hybrid cloud model due to "data residency" requirements. For example, countries like Germany, Belgium, Turkey, Brazil, China, and South Korea require data produced on citizens to stay in the country. The United States is also moving in this direction and has previously criticized social media growth company TikTok with allegations that it is sending data of US citizens to China. To solve this, TikTok will make use of a data residency plan through Oracle, which also works with hybrid cloud. Although Oracle is a competitor to IBM, this factor is not a negative, as it shows the potential for "smaller" cloud providers to fill a gap in the market where the "big guys" do not reach.

Another popular hybrid cloud application is in retail, which aims to use a hybrid cloud model to seamlessly converge and scale the online and offline activities of businesses.

IBM has made a large number of corporate operations (acquisitions) to bolster its hybrid cloud capabilities. In 2016, the company acquired Sanovi Technologies to enhance its hybrid cloud capabilities in areas such as cloud migration and recovery. Then in 2019, IBM acquired Red Hat for a staggering $34 billion in 2019, which is a hybrid cloud platform. This one in particular is seen as a great strategic acquisition as it allows its customers to build custom applications for a hybrid cloud environment. A good example would be a data residency setup (as mentioned with the TikTok agreement). The forecast is that other organizations (especially those in social media or finance) will follow a similar path, to keep data on US residents in the country. The recent increase in clients in the financial sector through Canadian Imperial Bank of Commerce (CIBC.US), was taken advantage of by IBM cloud to offer its hybrid cloud. In fact, banks will be a huge lucrative market, as financial companies have much stricter requirements regarding data privacy and are often wary of sending financial data to the "cloud." That fear of the "cloud" runs deep in banking, but hybrid cloud offers the best of both worlds. Since there are around 44,000 banks around the world, IBM has a huge opportunity in this space. Airlines are also another big area where safety is of the utmost importance. For example, the world's largest airline, Delta Air Lines, has a multi-year agreement with IBM to move its system to a hybrid cloud to help "modernize" and automate operations.

In 2022, IBM released its Red Hat Edge appliance, which is a low-friction solution for deploying "containerized" workloads with small internet-connected devices, from robots to point-of-sale terminals. This may seem like a small feature, but it offers great potential. These "containers" are the future of IT application deployment, as they are essentially packages that contain all the code necessary for an application to run. It is therefore not surprising that the global application deployment market is estimated to grow at a CAGR of 33.1%.

Platform strategy

In the following image we can see IBM's proposed platform approach, which includes Red Hat's hybrid cloud platform. This platform-centric approach basically means that when the company signs up a client for its applications, IBM gets a multiplier effect on its infrastructure revenue and any required consulting work. Therefore, the company does not need to become an infrastructure leader like AWS, since its strategy is different.

RedHat Hybrid Cloud Platform (IBM)

In fact, IBM has built a vast ecosystem of partners and expanded its presence in the markets of cloud infrastructure giants such as AWS (Amazon) and Azure (Microsoft). This is no small part of the company and revenue from SAP, Microsoft and AWS partners contributed more than $1 billion in full year 2022. IBM also has strategic alliances and integrations with Adobe and Salesforce, two major players in the software industry with a wide range of enterprise customers. Already in 2023, it launched its "Partner Plus" program, which aims to increase its scale through new and existing IBM partners.

Breaking down revenue by segment, IBM reported Hybrid Cloud revenue of $22.4 billion for 2022, up a solid 11% year-over-year or 17% in constant currency. This segment now contributes about 37% of total revenue and this is expected to expand in the future, which should boost IBM's overall growth rate. For the fourth quarter of 2022, its software revenue was $7.288 million, up 3% year-over-year or 8% in constant currency.

Breaking down revenue by subsection of the Software segment, IBM reported strong growth in its Red Hat platform, which increased sales by 10% year-over-year or 15% in constant currency. This was driven by the aforementioned tailwinds in the hybrid cloud industry. Its other Software, Automation, Data, AI and Security segments were also up 4% year-on-year and more than doubled in constant currency.

Segment revenue (IBM)

As we saw above, its "consulting" segment benefits from the multiplier effect of subscriptions to the platform. According to a study, 70% of IT decision makers believe they do not have employees with the right skills to help with a transition to the cloud. Therefore, IBM is leveraging its strong brand and technology expertise to help companies on their digital transformation journey. In the fourth quarter of 2022, IBM consulting reported $4.770 million in revenue, which increased 0.5% year-over-year or 9.3% in constant currency. This was driven by business transformation consulting (up 7% at constant currency), technology consulting (up 10% at constant currency), and application operations (up 12% at constant currency). Over the past 12 months, IBM consulting reported strong revenue of $19.1bn, up 7% year-on-year and contributing to more than a quarter of total revenue.

The IBM endpoint also reported infrastructure revenue of $4.480 million which increased 1.56% year-on-year or 7% in constant currency.

The AI opportunity

"Big Data" and "AI" are huge growth markets that IBM will benefit from. Many large organizations often have tons of data “silvered” but through the use of the cloud, IBM can help bring this data together and then run artificial intelligence and machine learning on it to unlock new insights. IBM has been an industry leader for many years and holds more than 2,300 AI-related patents. Additionally, the company is a Leader in the Gartner Quadrant for AI Developer Services below.

Cloud AI Developer Services (Gartner Diagram)

IBM's strategy is to focus on the productivity enhancements that AI delivers and believes it can help businesses run AI at scale. Example applications include the automated deployment of coronavirus vaccines and the use of AI chatbots to reduce call center resources.

For companies, implementing AI can be challenging because it takes time to train each model. But by using large language models, companies can now create multiple models using the same data set. This means that companies can implement AI with a fraction of the time and resources.

With the AI industry estimated to be worth more than $1.3 trillion by 2029, IBM has a great opportunity to capitalize on this trend.

Valuation and Forecasts

In valuing IBM, we've looked at consensus estimates, which put revenue growth at 6.5% for the full year of 2023. With added sensitivity to expected strong growth in its hybrid cloud segment.

Another important factor is to keep in mind that the company's R&D expenses will be capitalized over time, which may slightly boost net profit. With a growth base for the next 5 years of the operating margin of 20%, quite optimistic considering the global economic context of 2023, however it is possible. Given that the most recent quarter IBM posted a pre-tax operating margin of 19.8%. And previously already in the covid era, in the fourth quarter of 2020 its operating margin exceeded 32.4%. It is expected that in the long term, as the company continues to grow its software business, it should result in higher margins for the company as a whole.

Although the company's $50.9 billion in debt is extremely high, it has been reduced by $800 million since the end of 2021. Another positive is that the majority of its debt ($46.189 million or 90.7%) is "debt long-term" and therefore manageable by IBM.

IBM's valuation puts its final value at approximately $126 billion, which with a number of shares outstanding of nearly 906,000 shares, puts an intrinsic share price at 139,21$. Price level above the close of Monday, March 6 at 130,21$, and therefore with a discount of approximately 6.4%.

In addition, it is not common to see companies in the technology sector trading at a discount to their book value, quite the opposite. Making clear the opportunity that could be for long-term investors to have IBM in their portfolio.

As additional information, its non-GAAP P/E ratio of 14.35x is 21.56% above its average for the last 5 years. However, relative to other direct hybrid cloud competitors such as Oracle and technology companies such as SAP and Microsoft, IBM is trading at a higher discount using this ratio as a proxy.

Data by YCharts for Seekingalpha

Risks

Recession/Exit from Russia

Many analysts expect a recession in 2023. This may affect the number of customers moving to the cloud as they aim to slow spending cycles. On the positive side, we're not seeing any major signs of this yet. IBM's high debt could also be a risk, as although most of it is long-term, if interest rates don't fall back to low "normal" levels, this could mean a high cost of debt servicing for the company.

IBM is also facing headwinds from its exit from Russia, which has already cost it roughly $600 million in profit. However, if when the Ukraine-Russia war ends and there is a regime change in the country, Russia could open up in the long term (5-10 year period). This seems unlikely now, but let's remember that even Germany reopened after being involved in two world wars.

Final considerations

IBM has a strong brand name, more than 40,000 patents, and a large foundation of cutting-edge technology. The company's hybrid cloud and AI-focused strategy has great potential given the growth in the market and IBM's strong leadership position. The business is currently facing a number of headwinds due to a difficult foreign exchange market, but this will not have a long-term negative impact.

Dario Garcia, EFA
XTB Spain