There’s been some long-awaited good news for International Business Machines (NYSE:IBM) stock of late. Its earnings have been better. The company’s acquisition of Red Hat closed last month. And International Business Machines stock has rallied, with the IBM stock price touching a 10-month high late last month.
But that rally came after IBM stock, in December, hit its lowest levels since the financial crisis.
And the long-term performance of IBM stock remains sharply disappointing. IBM stock price is down by one-third from its highs. Even with dividends, the owners of International Business Machines stock are down 10%+ over the past five years.
So IBM certainly isn’t out of the woods, particularly after a sharp pullback of IBM stock price in the last week. IBM has some good attributes, but even with Red Hat, its long-term issue remains.
Specifically, IBM simply needs to start driving consistent growth. Until that happens, IBM stock will likely be “dead money” or worse.
The Red Hat Deal
The acquisition of Red Hat, which closed on July 9, makes some sense for IBM. As the company detailed in an investor briefing on Friday, Red Hat fits in nicely with IBM’s existing product set.
The tie-up creates a potential leader in the “hybrid cloud,” which marries the Linux open source operating system with IBM’s existing Public Cloud and OpenShift offerings. That combination ostensibly makes IBM a real competitor to the likes of Amazon.com (NASDAQ:AMZN) and Microsoft (NASDAQ:MSFT), who have tremendously grown their cloud businesses.
IBM can benefit from cross-selling by recruiting Red Hat’s customers to its hybrid cloud business and pushing Red Hat’s products to its existing customers. Strategically, the acquisition seems like a smart move.
But IBM paid a whopping $34 billion for Red Hat. The market wasn’t necessarily thrilled about that price: the IBM stock price actually fell on news of the deal. (To be fair, markets were tumbling in late October, when the deal was announced. It’s possible the reaction would have been different if the stock market had been in a more bullish phase.)
During Friday’s update, IBM didn’t exactly predict a massive earnings boost any time soon. Red Hat will lower the company’s 2019 earnings per share by an estimated $1.20, though about 90% of the hit won’t affect the company’s cash flow. But the interest on the debt required to fund the deal completely offsets its contribution to IBM’s cash flow.
In 2021, IBM is expecting Red Hat to raise its free cash flow by $1 billion. Given that IBM paid $34 billion for the company, it clearly needs consistent, steady growth from Red Hat going forward to justify the purchase price. At the least, right now, Red Hat’s performance alone doesn’t seem like enough to make the deal a game-changer for IBM or for International Business Machines stock.
How IBM Can Raise IBM Stock Price
Instead, for IBM’s performance to meaningfully rebound, its legacy business has to get back to growth. At least based on what we know, the Red Hat deal looks decent, but it was hardly a steal.
That characterization can change dramatically if Red Hat’s presence in the IBM portfolio can boost other areas of IBM’s business.
But those other areas continue to be a problem. IBM’s top line famously declined year-over-year for 23 consecutive quarters before its revenue rose YoY in the final quarter of 2017. But after two more quarters with positive top-line growth, the company has returned to its old ways: its revenue has declined YoY in each of the last four quarters, by an average of 3.6%.
That needs to change for IBM stock to even hold the gains it’s made this year (IBM stock price has climbed roughly 24% so far in 2019). And it’s going to be tough.
From a profit perspective, Watson, the company’s artificial intelligence venture, still seems like a disappointment. The mainframe business has boosted IBM recently, but IBM’s management admitted on its Q2 conference call that the mainframe upturn was coming to an end. New products will have to help on that front.
More broadly, IBM’s multi-year turnaround simply doesn’t appear to be all that successful yet. There’s been some progress, but IBM is posting declining sales at a time when many, if not most, of its end markets are growing. Red Hat alone can’t fix that problem.
The Case for IBM
With IBM stock price back at $140, it’s still tough to get too excited about International Business Machines stock. The recent decline has created a more favorable entry point. So does a 4.3% dividend yield – though IBM’s higher debt load post-Red Hat does raise the risk that the dividend will be lowered. (Don’t forget that seemingly safe dividend payers like Kraft Heinz (NASDAQ:KHC) and Anheuser-Busch InBev (NYSE:BUD) have made surprising dividend cuts after their recent acquisitions.)
An underlying change in IBM’s old businesses, maybe with some help from Red Hat, can change the trajectory of IBM stock. If IBM can become a real competitor in the cloud and use Red Hat to change its perception among customers and investors, IBM stock price can rise significantly.
But that “if” has been the case for most of this decade, and over the past ten years, the IBM stock price has gained a, total of 17%. Red Hat alone won’t change that, even if it can help around the margins.
As of this writing, Vince Martin has no positions in any securities mentioned.