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IBM and Red Hat Need to Prove the Skeptics Wrong

IBM stock has a lot more upside ahead if its Red Hat integration goes well

Up until this past week or two, International Business Machines (NYSE:IBM) stock has had a surprising year. IBM stock, which bottomed at $105 last winter, roared back to as high as $150, making for a cool 40% gain for anyone that bought near the lows. That said, IBM stock has retreated along with the rest of the market in recent days.

IBM and Red Hat: It's Time to Prove the Skeptics Wrong
Source: Shutterstock

Still, IBM has had several reasons for its turnaround. For one thing, the massive deal to acquire Red Hat is wrapping up now. As IBM starts to integrate Red Hat into its broader product offerings, it gives the company some great upside potential. Generally, analysts have been quite dour about the deal, saying the company overpaid and will still struggle to unseat the big dogs in the cloud. With expectations on the low side, International Business Machines stock could get moving if the Red Hat integration achieves reasonably good results.

A Huge Opportunity for IBM Stock

In an investor presentation earlier this month, IBM laid out the case for optimism following the Red Hat acquisition. It starts with a huge addressable market. IBM views the hybrid cloud as a nearly $1.2 trillion market. That breaks down as $550 billion for cloud services, $350 billion for cloud software, $150 billion for infrastructure and $100 billion for equipment sold to the service providers for cloud companies.

IBM at present has a roughly $125 billion market cap, so getting even a decent chunk of these fast-growing markets could turn the company’s momentum around after its years of underwhelming performance. IBM also notes that in a recent survey, 58% of businesses said that they operate multi-cloud environments. This gives IBM and other companies more opportunity to catch up to the established leaders like Amazon (NASDAQ:AMZN) and Microsoft (NASDAQ:MSFT).

The government’s current focus on concentrated power in the tech industry is another plus for IBM stock. President Donald Trump’s administration has made moves to rein in the big tech titans this year. These include having the U.S. Department of Justice and the Federal Trade Commission investigate the big companies and Trump tweeting specific provocations toward certain firms. For example, Trump recently accused Alphabet (NASDAQ:GOOGL, NASDAQ:GOOG) of meddling in the 2020 election via its search algorithm in a series of Aug. 6 tweets.

Against that backdrop, we have the military cloud decision. The U.S. Department of Defense was set to give a massive contract to Amazon or Microsoft. But thanks to the government’s worry about big tech’s monopoly power, this decision has now been delayed, opening the door to other players such as IBM.

The Dow Jones Index Factor

It’s important to note that the company’s performance likely isn’t responsible for all of IBM stock’s gains this year. We must also consider the effect of index investing on IBM stock. What’s going on here?

IBM stock is one of the larger components of the Dow Jones Industrial Average, which as you probably know, only has 30 stocks. What you might not know is that the Dow Jones is price-weighted rather than market-cap weighted. This means that the higher a company’s stock price, the more influence it has on the Dow Jones index. In parallel, it means that index funds such as the SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA) have much larger allocations to Dow components which sport a relatively high stock price.

So the highest-priced stock in the Dow, Boeing (NYSE:BA), which has bobbled around the $350-per-share mark over the past six months, is the largest member of the index. Stocks under $100 have far less exposure in the Dow index and related passive funds. IBM stock, given its relatively high price, is among the top 10 holdings in the Dow. These 10 stocks make up more than half the entire index. So when people panic and sell the Dow as an index, as they did last fall, IBM stock gets clobbered. When people buy the market back up, IBM stock gets a big lift.

This dynamic explains much of why IBM stock is doing so well compared to tech stocks that aren’t in the index so far this year. If the market keeps going up, this will be a big tailwind for IBM stock as passive money flows in. But as we saw over the past week, sentiment can reverse on a dime.

IBM Stock Verdict

This is an exciting time for IBM stock. The company has some serious momentum so far this year. For one thing, people are starting to wake up to the possibilities of the Red Hat acquisition. While the deal was mostly panned last year, analysts are rethinking it. Look at the hybrid cloud opportunity. If IBM can pull it off, the stock looks really cheap around $135.

Right now, IBM stock is selling for 11x trailing earnings, less than 10x forward earnings, and a nearly 5% dividend yield. That’s an incredible bargain in this market if IBM is able to return to any sort of consistent revenue growth. Even in a steady state where cloud growth offsets revenue declines in legacy businesses, investors would still make strong returns in IBM stock from this starting price.

Now it’s a question of execution. The vision and road map look great. But will they be able to deliver? IBM investors have suffered through years of underwhelming performance. Now is management’s time to prove the doubters wrong. In coming quarters, we’ll see if they can pull it off.

At the time of this writing, Ian Bezek owned IBM stock. You can reach him on Twitter at @irbezek.

Article printed from InvestorPlace Media,

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