International Business Machines (NYSE:IBM) may trade in a narrow trading range now that the stock trades ex-dividend. If IBM stock is stuck at between $143 and $140, income investors may not care too much.
Why is IBM stock at a discount at below 13 times earnings?
Mixed Third-Quarter Earnings
IBM reported a non-GAAP EPS of $2.68 but revenue fell 3.9% to $18.03 billion. With this poor performance, investors will start asking why the board did not replace the CEO and the management team yet.
IBM’s competitors like Microsoft, a business software and services provider, trades at 52-week highs. Microsoft’s cloud productivity software, Azure cloud, and enterprise software are all generating strong cash flow. Conversely, IBM’s growth is mixed.
IBM reported cloud revenue growing 14% year-over-year. Revenue topped $20 billion for the last 12 months. But IBM’s Red Hat acquisition helped drive the growth. Red Hat’s revenue growth accelerated to 20% Y/Y. Infrastructure grew in the double-digit pace, led by RHEL. App Dev and emerging tech, led by OpenShift and Ansible, added meaningfully to the unit’s strength.
Strength from Red Hat
Red Hat has a strong moat in the Unix operating system space. It is bringing innovation to the market by leveraging Linux, containers, and Kubernetes. And it is standardizing on the Red Hat OpenShift platform and bringing it together with IBM’s enterprise. This will position IBM to lead in the hybrid cloud market.
IBM generated strong cash flow and reduced its debt by $6.7 billion in the quarter. Pretax income took a hit due to a growth in operating expenses. The addition of Red Hat, transaction-related costs for equity, retention and higher expenses weighed on profits.
Troubling Balance Sheet
IBM’s low P/E reflects the weak balance sheet hurt by the Red Hat transaction. By taking out additional debt, IBM had $73 billion in debt by the end of June. $48 billion of that debt is core debt while $25 billion is for its financing business. The latter is supported by its financing receivables.
To accelerate the debt reduction program, IBM suspended its share buyback program. And by cutting almost $7 billion from its debt, it ended Q3 with $66 billion in debt.
IBM expanded its gross margin by 110 basis points, to 31%. A shift to higher-value offerings, yields on its delivery improvement, and productivity and utilization initiatives lifted this metric. Continued cost cuts and a search for greater efficiencies should result in higher gross margins ahead.
Revenue from IBM’s backlog is around 90% of next quarter’s revenue and 85% two quarters out. But lower customer business volume hurt Q3 revenue. Still, deal closings in the near-term should reverse the weak bookings.
IBM’s enterprise unit has plenty of strong prospects ahead. Customer demand for infrastructure modernization will continue. The trend for moving clients to the cloud will continue. Plus, IBM may also offer customers in leveraging Red Hat’s capabilities.
The Bottom Line on IBM Stock
The target for IBM stock price may not appeal to investors in the near-term. The company needs to accelerate revenue growth in the markets.
For example, its cloud and data platform revenue grew just 8% to $5.3 billion. Cross-selling of IBM and Red Hat solutions may justify a higher P/E and therefore a higher price target (per finbox.io).
Conservative investors may want to wait until after next quarter’s earnings report before adding to IBM stock. If the company reports stronger growth, then the upside potential for IBM greatly improves
Disclosure: As of this writing, the author did not hold a position in any of the aforementioned securities.