The big news in the M&A world this week was that blue-chip technology giant IBM (NYSE:IBM) is acquiring hybrid cloud company Red Hat (NYSE:RHT) for $34 billion, a steep 60% premium to the open source software maker’s market value. Wall Street largely praised the deal, with IBM stock analysts calling the deal “as transformative as it gets”.
But, investors weren’t so sure. The deal was announced on Sunday, Oct. 28. That previous Friday, Big Blue’s stock closed at $125. Today, it sits at $115.
Why the investor bearishness? Rates are going up, and IBM is presumably taking on a lot of debt to fund this deal. Thus, IBM’s balance sheet is being loaded up with debt at the exact time you don’t want to load up your balance sheet with liabilities. Investors are concerned about earnings and cash flows being pressured, and are ultimately worried that the extra debt burden will stop buybacks and/or force a dividend cut.
That won’t happen. Instead, the analysts have it right on this one. The Red Hat deal is a game-changer for IBM and, consequently, IBM stock. The tech titan needed to take action to boost its cloud business, which has been the only good thing about this company for the past several years. Recently, though, the cloud business has lost some luster as growth rates slipped and IBM fell behind competitors Amazon (NASDAQ:AMZN), Microsoft (NASDAQ:MSFT), and Alphabet (NASDAQ:GOOGL).
The Red Hat acquisition changes all that. It will boost IBM’s cloud presence, and ultimately improve long-term revenue and earnings growth prospects. Those improvements should drive IBM stock higher, especially from today’s depressed base.
As such, I think now is the time to get bullish on IBM stock.
The Red Hat Deal Is A Positive
IBM has been plagued by slow revenue growth over the past several years. While management has done everything in its power to cut costs and improve margins, sluggish sales growth has ultimately held back this company’s earnings power and kept IBM stock depressed.
The big concern is that this trend wasn’t reversing on its own. Bulls were hoping for out-sized cloud growth to shake IBM stock out of its slump. That didn’t happen. Instead, cloud growth rates have been cooling for several quarters now. Net result? IBM’s revenue improvement remains slightly down to flat, while earnings growth remains muted.
But, the Red Hat acquisition will reverse this trend. Red Hat is a major hybrid cloud player which dominates the all-important open source software component of the cloud. This company is a double-digit revenue grower with 85%-plus gross margins and 20%-plus operating margins. IBM, by contrast, is a flat revenue growth company with 50% gross margins and almost 20% pre-tax margins.
In short, IBM is acquiring a bigger revenue grower with a healthier margin profile. That is a recipe for success.
Moreover, Red Hat counts more than 90% of Fortune 500 companies as customers, and has 100,000-plus enterprise customers in total. The acquisition of Red Hat gives IBM a unique and valuable opportunity to cross-sell and up-sell cloud services to Red Hat’s huge customer base. Inevitably, this will provide a boost to IBM’s cloud business.
Overall, then, this deal is a major positive. Yes, it will cost IBM a boatload of money. But, it is ultimately worth it because Red Hat is the shot in the arm that IBM needs to reinvigorate growth in its key cloud business. Over the next several years, the IBM-Red Hat pairing will gradually gain share against the cloud’s Big 3 — Amazon, Microsoft, and Google. These shares gains will ultimately propel improved financial performance for IBM and send IBM stock higher.
IBM Stock Is Undervalued
After this most recent sell-off, IBM stock is vastly undervalued.
The shares now trade at just 8X forward earnings. That’s as cheap as IBM stock has been since the Great Recession. The price-to-sales multiple is at 1.3X, also the lowest level since the financial crisis. Same with the price-to-book and price-to-cash flow multiples. Meanwhile, the dividend yield is up at 5%, which is as high as it’s been in more than two decades.
Across the board, IBM stock is dirt cheap.
And dirt cheap only makes sense if IBM stock is prepping for massive revenue and earnings erosion, or a complete balance sheet wipe-out from too much debt. None of that is going to happen. Revenue growth will improve over the next several years thanks to the Red Hat integration. And, because Red Hat has bigger margins, earnings growth will improve, too.
Meanwhile, IBM is expected to generate $12 billion in free cash flow this year, and this is a depressed year. Thus, it would take IBM only three years of depressed operations to service a $34 billion debt-funded acquisition with free cash flow. That means the balance sheet isn’t all that burdened by this acquisition.
Bottom Line on IBM Stock
Overall, IBM stock is just too cheap here to ignore. This stock should bounce back from current levels, and ultimately trade way higher as the market starts to reasonably incorporate reinvigorated cloud growth prospects into the valuation.
And while IBM stock is dirt cheap and has plunged into oversold territory, the fundamentals are actually improving thanks to the Red Hat acquisition. Thus, recent weakness should reverse course, and IBM stock should bounce higher from here.
As of this writing, Luke Lango was IBM, AMZN, MSFT and GOOGL.