IBM Stock Is On Its Last Legs — Sell, Sell, Sell!

Valuation friction will keep IBM stock from heading much higher in 2019

It’s been a roller-coaster ride for shares of International Business Machines (NYSE:IBM) over the past several months. In late 2018, amid a broader market selloff, IBM stock dropped to near-decade lows below $110, after falling more than 30% over the course of two months. But at $110, IBM stock was simply far too undervalued. Thus, as broader financial markets have rebounded in 2019 amid stabilizing economic fundamentals, IBM stock has rallied, too. Year-to-date, IBM stock is up 25%.

IBM Stock Is On Its Last Legs -- Sell, Sell, Sell!
Source: Shutterstock

For IBM stock, that’s a massive rally. This is a stock that has been stuck in a consistent downtrend for the past five years. As such, this year’s 29% rally is actually one of the biggest rallies that IBM stock has staged in the last several years.

The overriding question now: can it last?

I’m not convinced. I was bullish on IBM stock in late 2018 since the valuation was out of whack with fundamentals. Specifically, you had a stock trading at multi-year low valuation levels with a multi-year high yield. This dynamic occurred amid improving fundamentals which implied that profit growth was going to return to the picture. Today, the fundamentals are still improving, and this company looks due for consistent profit growth over the next several years. But the current valuation appropriately reflects that growth outlook, so further upside is limited.

Consequently, this surprising 2019 rally in IBM stock seems to be on its last legs. Late-2018 buyers may want to do some profit taking here in early 2019.

The Outlook Continues to Improve

The story at IBM has been pretty bad for several years. Revenue growth has been consistently negative as the company was slow to pivot to the AI, cloud, and data markets. Furthermore, it has consequently been losing share in its legacy IT business. Margins have concurrently dropped amid stiffer competition in this space. Profits have been falling. IBM stock has been falling, too.

But there have been signs of gradual improvement over the past several quarters.

Specifically, the company has continued to push more aggressively into the cloud and AI markets. Subsequently, robust growth in these new businesses has largely offset declines in the legacy IT segment. Revenue growth rates have improved. Last year, constant currency-adjusted revenue growth was flat year-over-year for the first time since 2012. Meanwhile, thanks to these stabilizing revenue trends, margins have stabilized. Plus, pre-tax profit margins have been hugging the 17.5% level for three consecutive years now, after several consecutive years of huge declines.

These improvements should persist throughout 2019, mostly because the cloud and AI businesses remain on fire. Of note in 2019, IBM has announced a wide-ranging AI collaboration project with food giant McCormick (NYSE:MKC), formed a new 5G cloud-tech venture with Vodafone (NASDAQ:VOD), and scored a big IT deal with Juniper Networks (NYSE:JNPR). IBM has also landed a $700 million IT contract with Spanish bank Banco Santander (NYSE:SAN).

Broadly speaking, then, it appears that IBM’s cloud and AI businesses remain on track. So long as this remains true, then IBM is positioned to flip into positive revenue-growth territory soon.

The Valuation Reflects Reality

At this point in time, the valuation underlying IBM stock fully accounts for renewed revenue and profit growth. Therefore, it doesn’t leave much room for nearer-term upside.

When you look at IBM, you have a business that won’t grow by much over the next several years. At best, robust cloud growth and legacy IT market-share losses largely offset one another. At best, they produce tepid revenue growth of 0% to 1%. Meanwhile, margins should improve as revenue declines turn into revenue growth. But such improvements will be largely mitigated by competition in the broader IT market.

Consequently, IBM projects as a slow revenue grower with mild margin expansion potential over the next several years. Modeling that out, I think IBM can do about $15 in earnings per share by fiscal 2025. IBM stock’s trailing five-year average, forward price-to-earnings multiple is 10. But, over the past five years, revenues and margins were in free fall. Over the next five years, they should rise, albeit slowly.

As such, IBM stock deserves more than its historical average 10x forward multiple, but less than the market average 16 forward multiple. Using the midpoint of these two metrics, a reasonable fiscal 2024 price target of IBM stock is $195. Discounted back by 6% per year (4 points below my normal 10% discount rate to account for the yield), that equates to a fiscal 2019 price target of just over $145.

That’s roughly where IBM stock trades today. Thus, upside over the next several months looks limited.

Bottom Line on IBM Stock

In late 2018, IBM stock fell into deeply undervalued territory. That was the time to buy. Now, the stock has rallied more than 30% off those lows, and IBM stock is now in fairly valued territory. As such, late-2018 dip buyers may turn into early 2019 rally sellers. That’s a real risk for the stock going forward.

As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.


Article printed from InvestorPlace Media, https://investorplace.com/2019/04/why-2019-rally-ibm-stock-on-last-legs/.

©2019 InvestorPlace Media, LLC