IBM Stock Will Trend Higher on Red Hat Hybrid Cloud Opportunity

International Business Machines (NYSE:IBM) stock has declined by 14% to current levels of $129.50 from recent highs of $151.40. I believe that the current decline in IBM stock is an opportunity to accumulate for the long-term.

IBM Stock Will Trend Higher on Red Hat Hybrid Cloud Opportunity
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Let’s focus on the factors that can act as stock upside catalyst with emphasis on the company’s progress in the hybrid cloud opportunity.

As I write, Donald Trump has mentioned that China wants to be back to the negotiating table on the issue of trade war. If there is progress on this front, I expect the markets to rally and companies like IBM will benefit from any truce.

IBM Was the Cloud Market Laggard

It’s well-known that IBM has delivered sluggish quarterly and annual numbers in the last few years. One of the key reasons has been that IBM has failed to gain traction in the cloud business as compared to peers such as Microsoft (NASDAQ:MSFT) and Amazon (NASDAQ:AMZN).

To understand the reason for IBM being a laggard, it is important to differentiate between public cloud, private cloud and hybrid cloud.

Microsoft Azure provides a simple explanation

“A private cloud consists of computing resources used exclusively by one business or organization. Public clouds are the most common way of deploying cloud computing. The cloud resources (like servers and storage) are owned and operated by a third-party cloud service provider and delivered over the internet. Often called “the best of both worlds,” hybrid clouds combine on-premises infrastructure, or private clouds, with public clouds so organizations can reap the advantages of both.”

The relevance of this explanation for International Business Machines stock is that the company is primarily engaged in private cloud business.

However, the major growth in the cloud business has come from public cloud. This is the reason IBM has lagged behind competitors.

Game-Changing Acquisition

Public cloud. Private cloud. Hybrid cloud. Keep those distinctions in mind.

It’s been about 10 months since IBM announced the acquisition of Red Hat for $34 billion. That acquisition will serve as a catalyst for revenue growth and stock upside in the next 24-36 months.

To elaborate, IBM was a leading provider of private cloud services prior to the acquisition and the acquisition makes IBM a leading hybrid cloud provider. Therefore, it is “the best of both worlds” scenario for IBM.

Talking about the potential market size, IBM believes that the hybrid cloud opportunity is worth $1.2 trillion. Further, according to Allied Market Research, the global hybrid cloud market is expected to grow at a CAGR of 21.7% between 2018 and 2025.

With an increasing number of enterprises preferring hybrid and multi-cloud environment, there is room for IBM to accelerate growth.

As a part of the growth strategy, IBM intends to cross-sell Red Hat offering to existing clients to accelerate hybrid cloud adoption. There is ample growth opportunity: IBM has approximately 5,200 clients, with 4,500 of those not common with Red Hat. Even in terms of geographical reach, IBM will expand Red Hat’s offering in 30 countries.

IBM aims at achieving mid-single digit revenue growth by 2020-21 by leveraging on the hybrid cloud offering opportunity and the potential to cross sell products. I see that as likely, considering the company’s client base. With potential acceleration in free cash flows, IBM stock will also be positioned to deleverage.

Bottom Line on IBM Stock

It’s worth noting that Red Hat was growing revenue at around 15% to 20% as a standalone entity. With the acquisition, IBM intends to scale Red Hat by leveraging on its client base. At the same time, International Business Machines services will be marketed to industries catered by Red Hat.

It remains to be seen if the strategy translates into numbers. However, it is clear that IBM has a big opening in terms of making inroads in the hybrid cloud market.

It is also worth noting that IBM stock is marginally lower as compared to the levels when the acquisition was announced in October 2018. I see this as a good opportunity to accumulate. With the company providing a clear strategy for revenue and free cash flow acceleration, the stock should trend higher.

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

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