IBM (NYSE:IBM) enjoyed a post-earnings rally on July 17, which sent the stock close to yearly highs at over $150 a share. By August, that bullish sentiment changed. Markets started heading lower as the U.S. and China imposed punitive tariffs against each other. But that macro event cannot be the only thing that explains what happened to IBM stock.
IBM lowered its operating EPS forecast, blaming the lack of contributions from the Red Hat acquisition until the end of 2021. It forecast revenue growth in the mid-single digits. Operating EPS will be at $12.80 on the lower end. This is below the prior guidance of $13.90.
In its investor presentation, the company warned investors that the acquisition will result in near-term operating EPS dilution. This is driven primarily by a non-cash purchase accounting adjustment.
IBM Growth via Red Hat
But IBM tried to put a positive spin to the Red Hat addition. It forecast four to five percentage points in revenue contribution in 2020, followed by two to three points of incremental revenue contribution in 2021. On its own, Red Hat is generating over $1 billion in free cash flow annually.
Combined with acquisition-related charges and incremental interest to finance the transaction, it will add $500 million in FCF in 2020 and $1 billion in 2021. The 2-year waiting period unnerved investors, sending the stock from $150 in late July to a recent price of $131.17.
IBM is still up about 24% from its 52-week low. Plus, the stock’s decline raised its dividend yield to 4.89%. At inexpensive valuations of 10.9 times earnings, bargain hunters may start accumulating IBM stock at these levels. Conversely, cautious investors will notice that IBM now trades below its 20, 50, and 200 simple day moving average, a bearish sign.
IBM Stock Has Strong Long-Term Fundamentals
IBM is fundamentally shifting its services model from servers to the hybrid cloud. Red Hat Enterprise Linux is the software operating system that the back-end runs on. The architecture migrates to containers and kuberntetes, with OpenShift, the default choice for hybrid cloud. This increases IBM and Red Hat’s opportunity by tenfold.
OpenShift is a multi-cloud platform that creates opportunities for IBM. It may work with Accenture or Tata on the application development market. The on-premise infrastructure will involve HP (NYSE:HPQ) and Dell Technologies (NYSE:DELL).
Weak Short-Term Outlook
IBM cited the seasonality in its base business as a reason to expect lower revenue in the second and third quarter. This year, IBM forecasts base revenue falling between $1.3 billion to $1.4 billion from Q2 to Q3. A divestiture will remove $400 million in quarterly revenue, while Red Hat adds around $350 million in the third quarter.
The company also suspended its share buyback program to re-direct its free cash flow towards cutting debt levels. 2019 will mark the high point in IBM’s leverage ratio but it will fall for the next two fiscal years afterward.
IBM sees itself as the leading provider in a $1.2 trillion hybrid-cloud opportunity. This is because the firm specializes in providing services for cloud, developing cloud software solutions, and supplying hardware to support infrastructure. On the software front, IBM has experience in selling middleware solutions. Red Hat OpenShift on IBM Cloud gives customers the best end-to-end stack. IBM is confident that its hybrid multi-cloud platform may compete against Amazon’s (NASDAQ:AMZN) AWS, Microsoft’s (NASDAQ:MSFT) Azure, and Alphabet’s (NASDAQ:GOOGL, NASDAQ:GOOG) Google Cloud.
IBM Stock Takeaway
Investors may forecast IBM’s revenue growth potential based on its large addressable market for hybrid cloud in the years ahead. In a 5-year DCF Revenue Exit model, assume a terminal revenue multiple of around 1.9 times and a discount rate of 9%. This would imply a fair value for IBM stock that is 14% above its recent $131.17 closing price, or $147.62.
Technology stocks are all dipping in the last month due to trade war fears. And IBM clearly outlined its expectations for the year and its growth plan for the next few years. With Red Hat, IBM has a path for expanding its market. As profits grow, its stock price will trend upwards, too.
As of this writing, the author did not hold a position in any of the aforementioned securities.