This earnings season has been kind to tech companies. In addition to blowout reports from most of the hyper-growth FANG tech leaders, other lower-growth tech players like Intel Corporation (NASDAQ:INTC) and International Business Machines Corp. (NYSE:IBM) also reported solid quarterly numbers.
But not all these tech names — including Netflix, Inc. (NASDAQ:NFLX), Amazon.com, Inc. (NASDAQ:NFLX), and Alphabet Inc (NASDAQ:GOOGL) — should be treated the same.
After Intel’s blowout quarter, I wrote that the stock was a favorable way to play the artificial intelligence (AI) revolution. Growth was coming back in a big way, the valuation was still reasonable, and sentiment was inflecting upward.
Since its post-earnings pop, INTC stock is up another 4% in just a week.
After IBM’s strong quarter, I felt differently, writing that chasing the rally in IBM stock was foolish. Growth wasn’t coming back in any big way, the valuation wasn’t all that favorable, and the sentiment wasn’t showing any convincing sings of inflecting upward.
Since its post-earnings pop, IBM stock is down more than 3% in about two weeks.
I think IBM stock will continue to grind lower. I’m not a buyer until $140, a level I feel offers sufficient return potential considering the risk inherent in the name.
IBM’s Growth Story Not That Attractive
The thing about the IBM growth story is that there isn’t much demand for it.
A little less than half (45%) of IBM’s business is classified as Strategic Imperatives. This is the part of IBM’s business that’s attractive. It’s growing at around 10%. It has hyper-growth aspects, like cloud (+20%) and security (+49%). It also has stable growth aspects like mobile (+7%) and analytics (+5%).
Still, it is only half of IBM’s business.
The other half (55%) of IBM’s business is in secular decline, and it will remain so. Granted, as the Strategic Imperatives side of IBM’s business scales, it will start to comprise a bigger piece of the IBM revenue pie and drive positive revenue growth.
But that revenue growth will be meager. Strategic Imperatives revenue growth is already slowing year-over-year (10% versus 15% one year prior). Growth here will likely continue to moderate. Sub-10% improvement from IBM’s growth segment implies that overall revenue growth will be flattish. I’m sticking with my call for 0-1% revenue growth over the next several years.
There really isn’t much demand for such pedestrian top-line growth, especially against the backdrop of continued gross margin erosion. Management expects margins to rebound next year, but any rebound will be small. Overall, then, this is a growth story with low single-digit earnings growth potential.
IBM Stock Numbers Aren’t So Pretty, Either
Over the past five years, IBM stock has traded, on average, around 12x earnings.
Considering growth prospects aren’t going to change all that much in the foreseeable future, there is no reason why IBM should trade at a premium to that five-year average price-to-earnings multiple.
Earnings are expected to crawl to about $14.32 by fiscal 2019. A 12x multiple on $14.32 earnings implies a two-year forward price target of about $172.
That is just 12% upside over two years. Not very good. It also isn’t great considering all the growth is coming from less than half of the total business. Plus, the balance sheet is loaded with debt, pushing IBM’s enterprise value significantly higher than its market cap. Indeed, the current enterprise value-to-EBITDA multiple is 10.4, a near 15% premium to the trailing five-year average EBITDA multiple.
Bottomline on IBM Stock
From these levels, long-term upside on IBM stock is greatly limited.
I like to shoot for 10% annualized return. That would mean I’m a buyer of IBM stock around $140.
Until then, I think its best to wait on the sidelines with this low-growth name and put your money to work elsewhere, like INTC.
As of this writing, Luke Lango was long INTC, AMZN, GOOG, and NFLX.
