After many rough years, 2019 has been a good year for International Business Machines (NYSE:IBM) stock. The stock is up over 27% year-to-date. But are investors ready to reward Big Blue for its efforts to reinvent itself? That’s less clear. And a lot of the concern has to do with IBM’s acquisition of Red Hat. While the move has been largely praised as being both bold and necessary, it’s also expected to dilute earnings through at least 2020.
The problem is one of expectations.
Investors are familiar with the IBM story. They know the company is trying to pivot away from its legacy business. However, IBM has had muted success with cloud computing, artificial intelligence and mobile. So investors seem to be a bit wary of how the company will execute its plan with Red Hat.
However, while these low expectations are a challenge, they can also signal an opportunity for International Business Machines stock.
This is Not the Same Old Big Blue
Since 2012, IBM has been conspicuously transitioning its business model. The development of its “Strategic Imperatives” group brought IBM into areas such as cloud computing, artificial intelligence and mobile. This has not gone as smoothly as investors would like. IBM still lags behind competitors like Amazon (NASDAQ:AMZN) and Microsoft (NASDAQ:MSFT). A migration path like this requires a massive investment, and IBM was not delivering the revenue numbers to support such an investment.
However, in 2018, that move started to pay off. In the second quarter of last year, IBM reported that for the first time, the Strategic Imperatives group brought in over half of the company’s revenue. The problem is that while IBM showed a 3.6% year-over-year growth in revenue for that quarter, it has posted declining sales in the last four quarters.
For Now, Red Hat Will Continue to Dilute Earnings
In the 1990s, Big Blue took a defensive posture to open-source software. However, seeing the inevitable decline of its legacy business, the company has done an about face with its $34 billion acquisition of Red Hat.
By becoming a part of IBM, Red Hat has an opportunity to expand into countries where it has little or no current presence. And IBM still believes there is massive potential for the cloud space, arguing that only 20% of the data in a typical enterprise has transitioned to the cloud.
IBM is also forecasting additional revenue as it sells more IBM software via Red Hat’s OpenShift container platform. This platform supports public and private clouds including those of Amazon, Microsoft and Alphabet (NASDAQ:GOOG, NASDAQ:GOOGL).
But the real payoff won’t happen until 2021 at the earliest. For now, the acquisition will continue to have a dilutive impact on IBM’s adjusted earnings. The largest negative item will come from the deferred revenue adjustment. Red Hat had $2.8 billion of deferred revenue on its balance sheet at the time the acquisition closed. IBM took a charge of $2.2 billion which is reducing its deferred revenue balance to $0.6 billion.
What’s Next for IBM Stock?
At one point during 2018, IBM stock was dead last among the Dow Jones Industrial Average components. The stock consistently traded below its fair market value as investors were skeptical about the company’s efforts to pivot.
The question for investors now is revenue. For the last two quarters, IBM has beat on the bottom line but has failed to beat revenue expectations. The launch of the z15 mainframe may help, but it doesn’t seem like the real revenue spigot will open until the Red Hat investment begins to pay off.
Are investors willing to ride it out? A closer look shows that IBM stock is not priced for success. Other “cloud” companies like Amazon and Microsoft have valuations that are baking in their future success. On the other hand, IBM has a trailing price-to-earnings ratio of 14.9 and an expected earnings per share of $12.81. IBM stock is priced for more of the same performance that has disappointed investors for several years.
It’s tough to make a growth case for IBM stock at this time. Investors will probably have to take a wait-and-see approach. However, value investors can still enjoy an appealing dividend of 4.5% and a stock that, at least for now, shows no signs of heading back to its December 2018 levels.
As of this writing, Chris Markoch did not hold a position in any of the aforementioned securities.
