How IBM Has Become a Growth Stock Again

International Business Machines Corp. (IBM) is showing signs of life in 2019 after about eight years of declining revenue and a stock that cratered roughly 37% from adjusted closing highs reached in October 2012 to a low in December of last year. But Big Blue looks to have turned a corner. So far this year, shares of IBM are outperforming the broader market, up 26% compared to the S&P 500’s year-to-date gain of 19%, suggesting there’s more to the recent comeback than the general momentum of the stock market’s 2019 rebound.

What it Means for Investors

Helping to fuel IBM’s performance is its recent acquisition of software and cloud-computing firm Red Hat, a move that is in line with CEO Ginni Rometty’s goal of reorienting the company towards what she refers to as high-value businesses. It has not been an easy road for Rometty, who first took over the reigns at IBM in 2012. But her work over the past seven years may be finally starting to pay off. 

Key Takeaways

  • IBM shares fell 37% from peak to trough over six years.
  • Shares have climbed back 26% this year, outperforming S&P.
  • Quarterly revenue decline of 4% over past eight years.
  • Company has reoriented towards new technology and the cloud.
  • Red Hat acquisition is a big catalyst of the recent comeback.

The Decline

Rometty took over at a time when the ship was just starting to sink. Of the past 24 quarters (i.e. eight years) IBM has reported declining revenue in 21 of them, with an average decline of 4% per quarter, according to Barron’s. Traditional engines of growth that the company had excelled at in the past, such as equipment and sales and services, were slowing. It was clear that the company could either die a slow death or look for new engines of growth. Rometty chose the latter option.

IBM has since poured more and more of its resources into new technology like artificial intelligence (AI) and blockchain, and is pushing hard into the market for cloud-computing infrastructure. Signs that the strategy was working first came in the last quarter of 2017, when revenues suddenly rose after falling virtually every quarter since Rometty had taken over. Revenue continued to rise during the first half of 2018, but then began declining again in the latter half of the year.

The Comeback

Amid revenues that were once again falling, IBM announced plans to acquire Red Hat in October 2018, in what Matt McIlwain of Madrona Venture Group LLC called “a bet-the-company move,”. The deal was completed in July of 2019. Shares of IBM continued to fall with the rest of the market throughout 2018, but many analysts became optimistic about both the short-term and long-term prospects of the acquisition and it is likely a big reason for the stock’s outperformance this year.

IBM 1 Year
IBM 1 Year Chart.

No doubt, the Red Hat acquisition is a big deal, in numerous senses of the phrase. When the deal was first announced, it valued Red Hat at a purchase price of $33 billion, approximately 30% of IBM’s market capitalization at the time. IBM eventually paid $34 billion for the firm, making it not only the company’s largest acquisition ever, equalling roughly the combined value of the deals it has done in the past 15 years, but it is also one of the largest deals in U.S. tech history.

The hope is that Red Hat will help IBM more effectively penetrate the cloud-computing market, and that the combination will allow IBM to sell more of its software to Red Hat Users and get more of its IBM customers to become Red Hat users. “OpenShift [a Red Hat product] should help IBM win new customers and new workloads as enterprises begin to usher mission-critical applications from on-premise to public or private clouds,” wrote Nomura Instinet analysts led by Jeffrey Kvaal in a note back in April.

Future Goals and Challenges

In a webcast meeting with analysts in early August, IBM laid out a much-awaited roadmap of the company’s future goals. Noting that it sees a more than $1 trillion opportunity in the hybrid cloud market as companies continue to shift their critical business functions to the cloud, IBM said it expected revenue to begin growing in the mid-single digits as early as the second half of this year. Earnings per share (EPS) will take a near term hit to reflect accounting rules related to the Red Hat purchase. 

More specifically, IBM expects the Red Hat deal to boost revenue in the second half of the year by about 2%, another 4%-5% in 2020, and 2%-3% in 2021. Free cash flow (FCF) is still forecasted to come in at around $12 billion for the year, but an additional $500 million will be added next year, and another $1 billion in 2021. With numbers like that, IBM is starting to look like a growth stock again.

Looking Ahead

The big challenge associated with pushing further into cloud computing is having to compete with big name’s like Inc. (AMZN) and Microsoft Corp. (MSFT), which currently dominate the market. As of 2017, IBM was ranked fifth in the world for providing public cloud-infrastructure. Improving that ranking won’t be easy, but at the very least, trying to improve will likely help boost its stock, which is still about 12% below its all-time high.

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