Two weeks ago, IBM (NYSE:IBM) reported a double-beat quarter that comprised the company’s best revenue growth rate in recent history. IBM stock jumped from $145 to $150 in response.
But, the rally wasn’t sustainable. IBM stock has since fallen off its post-earnings highs and now trades at $145, exactly where it was before earnings.
Why the pop-and-drop in IBM stock? Because IBM is plagued by slow growth. That “best revenue growth rate in recent history” is just 2% revenue growth. Meanwhile, margins aren’t powering higher in any meaningful way and profit growth isn’t exactly robust.
Going forward, the company’s growth prospects aren’t great, either. The cloud and security businesses have a nice runway, but, overall, it looks like IBM is stuck in this sub-2% revenue growth era.
Thus, the drop in IBM stock is attributable to investors realizing that there is no reason to pay a premium for this permanently low-growth company.
Having said that, IBM stock is dirt cheap. And, as it drops towards $140, the stock could quickly become a short-term buy.
Here’s a deeper look.
IBM Is Plagued By Slow Growth
At its core, IBM is broken into two segments: Strategic Imperatives and everything else.
Strategic Imperatives is the company’s collection of high-growth businesses that range from cloud to analytics to security. Growth in this segment is promising (+13% last quarter) and accelerating (year-ago growth was 7%). The outlook for continued healthy growth in this segment is also promising, driven by increased demand for cloud, security and analytics-related solutions.
But everything else at IBM is in retreat. The legacy business continues to fall and become less and less relevant each quarter. Thus, with the legacy segment in retreat, it is up to the Strategic Imperatives segment to power growth.
Unfortunately, growth in the Strategic Imperatives will either stagnate or slow going forward.
The security business is ramping from a very small base. As that base scales over time, growth rates will come down, regardless of how big the secular tailwinds are in cybersecurity. Meanwhile, the cloud business is only growing at a 17-18% clip, which is rather anemic for a cloud business. The whole cloud market is growing at a 20%-plus clip this year, so IBM continues to lose market share to the likes of Amazon (NASDAQ:AMZN), Google (NASDAQ:GOOG) and Microsoft (NASDAQ:MSFT).
Worse yet, cloud market growth rates are expected to moderate over the next several years and fall to 16% by 2021. Thus, IBM’s present 17-18% cloud growth rate will likely also fall to around 12-13% over the next several years.
Overall, while Strategic Imperatives growth is accelerating higher, this isn’t the new norm. Growth rates will moderate from here, and IBM will remain an exceptionally low-growth company.
$140 Could Be a Good Short-Term Entry
At the end of the day, though, it is all about valuation. And at $140, the valuation on IBM stock becomes compelling, even considering its low-growth nature.
Going forward, IBM is a 1-2% revenue growth company. Gross margins are still falling. But management’s focus on cost-cutting is allowing the company to bring its operating expense rate down. Thus, pre-tax profit margins actually rose year over year in the second quarter.
Sizable and consistent opex leverage will be difficult against the backdrop of 1-2% revenue growth. Nonetheless, I do think it is possible that 1-2% revenue growth creates a pathway for pre-tax margins to get to 20% in five years (versus 17.5% last year).
That combination of 1-2% revenue growth and 20% pre-tax margins leads me to believe that IBM can do about $16.50 in earnings-per-share in five years. The market trades around 16X forward earnings, but the market is also growing earnings at a 16% clip. IBM is growing earnings at a far slower rate, and as a result, IBM stock has historically traded around 10X forward earnings, with a five-year high forward multiple of about 12.5.
A 12.5 forward multiple on $16.50 implies a four-year forward price target of just over $206. Discounted back by 10%-per-year, that equates to a present value on IBM stock in the mid-$140’s.
Thus, any drops to $140 would put the stock in undervalued territory.
Bottom Line on IBM Stock
IBM stock is plagued by slow growth. Because of the slow growth nature of the company, IBM stock won’t be heading towards $200 any time soon.
But, IBM does still have some growth left in the tank. At $140, that growth is undervalued. Consequently, IBM stock is a buy if the stock sells off towards $140.
As of this writing, Luke Lango was long AMZN and GOOG.
