When looking at International Business Machines Corp. (NYSE:IBM), it’s easy to set focus on the fact that IBM stock has had a good year, even though certain parts of its business core are slowing down.
After all, its net income in the third quarter of 2016 dropped to $2.853 billion from the $2.950 billion it reported during the prior-year quarter.
In addition, its net income for the first nine months of 2016 was $7.371 billion, a $1.356 billion drop from the net income it reported for the first nine months of 2015. Moreover, its revenues have also declined relative to the third quarter of 2015 as well as the first nine months of 2015. But even with less-than-impressive performance, IBM stock has managed to gain north of 19% year-to-date, belittling S&P 500’s 9%-plus gain.
Congratulations if you bought International Business Machines stock around February of this year when the stock was still depressed. You got it when the value in IBM stock was still very deep. However, if you’re thinking about buying more of the stock, this might be best time, as value still lurks here.
Here’s why.
The IBM Cloud Business Is Growing
International Business Machines has been working to reduce its reliance on its traditional enterprise business, to focus on its strategic imperatives segment. This segment consists of its cloud computing, artificial intelligence, analytics and security businesses. IBM’s initial target was for this segment to account for about 40% of sales, on a trailing twelve-month basis (or an annual run-rate).
International Business Machines achieved this feat in the third quarter. IBM CFO Martin Schroeter said during the third-quarter earnings call that the strategic imperatives segment delivered roughly $32 billion in revenue over the trailing-twelve-month period, representing about 40% of International Business Machines’ revenue. He noted specifically that IBM’s cloud offering was a huge growth driver. In the third quarter, cloud business grew by over 50%.
The reason you should like IBM’s cloud business lies in the way the company is growing it. International Business Machines has been on an acquisition spree. The company knows that it’s already way behind the likes of Amazon.com, Inc. (NASDAQ:AMZN) and Microsoft Corporation (NASDAQ:MSFT). So it’s a smart choice to grow its cloud business through acquisition. As of the end of the third quarter, IBM stock has spent approximately $5.5 billion in acquisitions.
With its strategic imperatives accounting for 40% of International Business Machines sales already, chances are the company has been very efficient in its acquisition process. This offers hope that its future acquisitions will help grow its cloud business even more.
Yes, IBM is still behind in the cloud wars. As of the second quarter, Amazon Web Services’ annual run rate was $11.5 billion.
However, I believe that the cloud business is so huge that you don’t have to own the biggest share of the market to be respected. And IBM stock is definitely one of leading cloud services providers.
IBM Stock Is Undervalued
While International Business Machines, Amazon and Microsoft are diversified, I’d like to compare IBM with these two because the cloud business has been one of the biggest drivers of AMZN stock and MSFT stock in recent times.
IBM stock boasts of a lower price-to-free-cash-flow ratio than both Amazon and Microsoft. Its price to FCF stands at 11, while Amazon and Microsoft have ratios of 43.1 and 18.2, respectively.
What’s more, IBM has been seeing its price to FCF ratio decline continuously over the last three years. MSFT’s price to FCF has been on the rise. And when you factor that IBM has grown its FCF by over 8.8% in the last three years, it becomes more obvious that the market has been discounting its FCF.
Moreover, since cloud is a big determinant of what IBM stock and MSFT are expected to earn in the near future, it also make sense to look at the forward price-to-earnings ratios. I won’t include Amazon here because its e-commerce business contribution is huge. IBM stock offers a forward P/E ratio (one year) of 11.8 compared to MSFT’s 19.
For more perspective, the S&P 500 average one-year forward earnings multiple is 18.
Put simply, the growth International Business Machines is seeing in its cloud business is not being valued adequately by the market. On top of this, IBM stock pays an attractive $5.6 annualized dividend.
As of this writing, Craig Adeyanju did not hold a position in any of the aforementioned securities.
