International Business Machines (NYSE:IBM) is depending on its hybrid cloud strategy to boost its slowing growth. IBM needs to gain traction in the hybrid cloud market with its recent Red Hat acquisition. If it succeeds, IBM stock will do well over the next year.
Companies use hybrid or multi-cloud services that Red Hat offers to manage their software across different cloud services and their own data centers. IBM is counting on Red Hat to give it clout in competition against Amazon (NASDAQ:AMZN) and Microsoft (NASDAQ:MSFT)
Companies use separate cloud services to put their data to work. These services sort, group and analyze it quickly and securely. For example, Red Hat’s software helps companies put older software applications in data centers and in various cloud services.
IBM’s strategy to turn around its software revenue is hanging on this, according to the Wall Street Journal. One analyst quoted by the Journal called the Red Hat deal a “bet-the-company move” by CEO Ginni Rometty. This is because none of her other acquisitions in the past seven years have amounted to anything great.
Upcoming Earnings Will Highlight Red Hat’s Benefits
On Oct. 16, IBM will report its third-quarter earnings. This will be the first full quarter of having Red Hat as a separate subsidiary. This will be important as it will begin to show how Red Hat will add to IBM’s overall growth plans.
Red Hat has been growing its revenues at a much faster growth rate than IBM. Its three-year revenue growth rate is 20% against 1.5% for IBM.
The upside for IBM and Red Hat in the hybrid market is huge. IBM claims this is a $1.2 trillion opportunity. For example, by 2023, 50% of businesses will have moved to the “write once, run anywhere” multi-cloud environment. This is up from 10% of businesses having that ability now.
IBM’s cloud revenue as of Q2 was $19.5 billion for the past 12 months. This represents just 25.5% of its total revenue during that period. Red Hat is expected to add $500 million to IBM’s free cash flow by 2020 and $1 billion by 2021. As of Q2 IBM had made $12.2 billion in free cash flow over the last 12 months. So that means even if Red Hat contributed $1 billion this year, the increase in free cash flow would be 8.1%.
IBM Stock Is Beaten Down Compared to its Peers
In June 2019 a UBS analyst upgraded IBM to a “buy” rating and lifted his target to $180 per share. He believes that IBM’s revenues will turn around as it focuses on higher-margin businesses like cloud computing, analytics and security.
IBM stock is trading for just 11 times forward earnings. This seems too cheap for a company that now has a chance to turn its earnings and cash flow around with its Red Hat acquisition.
Moreover, with the 4.5% dividend yield, investor receives a nice return while waiting for IBM stock to rise. This is significantly higher than the average 1.9% dividend yield of the S&P 500.
Value Investing and Ignoring the Market
Two famous value investors were interviewed recently in an article in the Harvard Business Review titled “Value Investing, Human Behavior — and Why You Should Ignore the Market.” In the article the investors were asked why some companies appear to be selling for significant discounts to their intrinsic value. One of the investors, Charles Brandes, had a great answer:
“…If you do a deep analysis of a company that is in trouble, sometimes you can see that the problem is not going to last forever. For example, Volkswagen during its emission crisis, and BP during the oil-spill debacle. These were horrible, but temporary, situations for really good companies — and that can provide an opportunity to buy them below their actual value.”
I believe that is the situation here with IBM stock at these prices. You can see that the Red Hat is going to act as a catalyst for the company to reach its true earnings potential over the coming years.
IBM Stock Has a Good Chance of Paying Off for Value Investors
IBM stock has discounted a lot of bad news. It seems none of the benefits of the Red Hat acquisition have been incorporated into its valuation. This seems like a good entry point for value investors.
They need to be willing to wait for the Red Hat acquisition to start adding value for IBM. But it seems the wait will be worth it in the long run.
As of this writing, Mark Hake, CFA does not hold a position in any of the aforementioned securities. Mark Hake runs the Total Yield Value Guide which you can review here. The Guide focuses on high total yield value stocks, which includes both dividend and buyback yields. In addition, subscribers a two-week free trial.