International Business Machines (NYSE:IBM) has gone nowhere in the past 5 years. In fact, IBM stock is down more than 12% over that period. In the last year alone, the stock is up only 7%. But much of that jump occurred in the last month (up 3%).
The point is that this kind of performance is nothing to write home about. And the prospect of IBM rising much over the next year, despite being cheap, is not that great as well.
IBM vs Microsoft
Part of the reason is that IBM is not really seen as at the forefront of what is “sexy” in software. For example, it’s not leading in tech trends like artificial intelligence (AI). And the company is desperately trying to establish itself as a major cloud support software company like Microsoft (NASDAQ:MSFT).
Of course, it lost out in the innovation race with Microsoft a long time ago. IBM stock has a market capitalization of $121.3 billion. Compare that to MSFT stock’s market cap of $1.93 trillion, and you’ll see that its competitor is more than 15 times greater.
But there’s another, more interesting point to make with this comparison. IBM made $73.6 billion in revenue last year, and Microsoft had $153.3 billion. That is just a little over twice the revenue at IBM, but its market valuation is 15 times greater. In other words, the market likes Microsoft’s revenue and earnings much better. And of course, MSFT stock is up 360% in the past 5 years, not down 12% like IBM stock.
One reason for this discrepancy in valuation is that Microsoft has greater profitability. For example, Microsoft makes over 50% more free cash flow (FCF) on a margin basis than IBM. This means that for every dollar of revenue at IBM it makes 21% in FCF on that revenue vs. 33% margins at Microsoft.
Here are the numbers: last year Microsoft made $50.4 billion in FCF on $153.3 billion in revenue (i.e., 33% margin). IBM’s margins were lower — it made $15.58 billion in FCF on $73.6 billion in revenue (21% margin).
In other words, the quality of earnings and FCF at IBM is below a major peer. That is why the market values MSFT stock so much higher.
Why Cloud Revenue Matters
One of the reasons for the lower quality earnings is that IBM is playing catchup with its cloud revenue division. It still accounts for just $25 billion of its $73.6 billion in total revenue, or a little over one-third.
This revenue is highly profitable and is usually recurring in nature. Most clients are reluctant to change their cloud server provider once established or change around with a new cloud service provider on a frequent basis.
However, IBM is doing better in this regard. The company reported that its cloud revenue was up 20% after adjusting for divestitures and currency effects. This is much better than total revenue, which actually fell 5% last year. However, its Q4 cloud revenue grew just 8% year over year after divestitures and currency.
What To Do With IBM Stock
This matters to the market. That is why IBM stock now has an FCF yield that is much higher than MSFT stock (i.e., it’s not valued as high). For example, IBM’s $15.58 billion in FCF divided by its $121.3 billion market cap is 12.8%.
That is a very high FCF yield. Compare that with Microsoft’s FCF yield. Microsoft’s $50.4 billion in annual FCF compared to its $1.93 trillion market value results in a FCF yield of 2.61%. In other words, the market places a much higher value on Microsoft’s FCF … Microsoft’s higher FCF margins.
One might be tempted to say IBM stock should be valued at a 2.6% FCF yield. But that disregards the huge discrepancy in FCF margins. Even if we adjust for this — by giving it a 21% FCF margin, which is 61.7% of MSFT’s 34% margins — IBM stock should be at 67% of the Microsoft FCF yield.
That would work out to a 4.2% FCF yield for IBM stock (the formula for this is somewhat complicated). The net result is that we divide IBM’s $15.58 billion in FCF by 4.2%. That implies a target market cap of $370.93 billion, or 3 times its present price.
But it is not as simple as that. IBM’s cloud revenue is still less than 50% of the company’s total revenue; whereas, Microsoft has many software products that are highly recurring in nature. At best I suspect that IBM is worth maybe less than half its present 12% FCF yield or 7% or 8%.
In other words, divide $15.6 billion by 8% and the result is $194.7 billion. This implies a target price that is 61% higher than today, or $213. If it takes 5 years for that to happen, the average annual gain will be 9.9% per year. In other words, don’t expect IBM to rise more than 10% a year over the next 5 years.
On the date of publication, Mark R. Hake did not hold a long or short position in any of the securities in this article.