International Business Machines (NYSE:IBM) looked as though it would hold the $150 level in July and move higher from there. On July 17, the company reported quarterly results that the markets liked. Since then, IBM stock has gained 2.3% while the S&P 500 index has lost 2.8%.
So while IBM’s move up beat the market, it’s left a nagging feeling that there should’ve been more. Were markets just discounting the stock ahead of today’s ex-dividend deadline? Or did folks just not like the investor presentation on Aug. 6?
That briefing outlined IBM’s assessment of its open-source platform. As Morningstar’s Andrew Lange wrote, “… the messaging was clear: IBM is chasing the $1.2 trillion hybrid cloud opportunity.”
In effect, the company was justifying its Red Hat purchase for $34 billion, a deal which closed on July 9. Red Hat is a successful product in the enterprise because it has many reference standards. OEMs have access to more workloads, while public clouds allow access to more workloads in hybrid environments. Customers installed Red Hat’s Enterprise Linux as the default choice for the operating system. From there, Red Hat’s Openshift Container Platform, a hybrid cloud, gave the unit a 10x opportunity.
IBM did not include Red Hat’s numbers in its second-quarter results. When it does, its next chapter of cloud will be around shifting mission-critical work to the cloud. As it optimizes functions such as shifting mission-critical work or core banking systems, the solution will easily support the heavy workload levels.
These hybrid environments complement IBM’s own offerings — IBM Cloud, IBM Cloud Private, and the Cloud Migration Factory are just a few innovations that have hybrid cloud capabilities. The market is so big that IBM reported $19.5 billion in cloud revenue in the last year, up 8% year-on-year and led by its service capabilities growing in the mid-teens.
Higher Expenses from Red Hat Investment
IBM’s base expense rose in the second quarter as it invested ahead of the Red Hat deal closing. Developments in its next-generation IBM Z for later this year will add meaningfully to results in the year ahead. Investors should note that IBM suspended its stock buyback following the Red Hat transaction. Still, its balance sheet is healthy with $46 billion in cash. It used $34 million to close the deal.
Total debt was $73 billion, bringing its debt/equity to above 4x. So long as IBM continues generating strong free cash flow, shareholders need not worry over the debt levels. Besides, with its global financing debt down more than $6 billion from last December, the credit quality of its financing portfolio is better.
IBM’s gross margin expansion and solid free cash flow in the second quarter suggests that the business overall is healthy.
Outlook with Red Hat in the Family
With Red Hat, IBM expects revenue growing 200 basis points more over five years. Operating margin will be accretive in the first year while operating EPS will be by the end of the second year. In 2020-2021, revenue will grow in the mid-single digits. Operating pre-tax income will grow in the high single digits. Much of the dilution from the acquisition will be driven by non-cash items. Expect a deferred revenue adjustment weighing on results in the next year. But by the end of 2021, Red Hat will add $1.5 billion in incremental free cash flow, helped by continued margin expansion. Profitability will improve from shifting to higher-value customers.
Although IBM will have higher debt levels, it will use its cash flow to lower its leverage ratio while still committing to dividend growth. If investors assume stable dividend growth with a yield in the 5.5%-6.2% range, then the stock’s fair value is more than 10% higher than its recent $140.73 closing price.
Your Takeaway on IBM Stock
Red Hat strengthens IBM’s positioning in the hybrid cloud market. While its cloud revenue in the last 12 months is solid, the acquisition will only accelerate its free cash flow growth and profitability. Non-cash write-downs may hurt the share price in the next quarter but prospects are stronger than before. After the stock fell around 6% in the last week — while the S&P lost 2% — investors should consider investing in IBM stock once again.
Disclosure: As of this writing, the author did not hold a position in any of the aforementioned securities.
