Stockwatch: why IBM is heading for the clouds

This tech giant is good value and offers more attractive risk/reward than highly rated rivals, argues our companies analyst.

As US results reporting season builds up steam, shares in International Business Machines (NYSE:IBM) jumped about 6% in after-market trading following results which slightly beat consensus. 

However, like-for-like numbers within the group’s two legacy operations were modestly down and the “cloud” side – in which hopes for growth are vested – edged up only 3%. Unlike some other IT stocks benefiting from people working at home, IBM’s dilemma is being tied largely into corporate capital spending that has been slashed during the period, in order to cover vital operating costs.

I last drew attention to IBM as a ‘buy’ at $143 in January 2020, given the stock offered investment grade criteria by way of a forward price/earnings (PE) ratio of 10x versus over 19x for the IT sector generally. This compared with Amazon and Microsoft on PE’s of 84x and 31x respectively. Price/sales ratios and a 4.5% yield also compared favourably versus Qualcomm on 2.6% and Cisco on and 2.9%.

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Reaching for the cloud

He transformation of legacy IBM services towards cloud was part of my rationale when originally making a case to accumulate stock from $131.5 in January 2019. The then CEO had also heralded 2018 as “a very important inflection year” with revenue, operating income and earnings per share (EPS) all up for the first time in a long while. 

The $34 billion (£26 billion) acquisition of Red Hat Inc, which completed a year ago, underlined this shift towards software – operating systems, cloud, mobile and storage.  Against expectations, Red Hat’s CEO would take that role at IBM, the board chose IBM’s head of cloud and cognitive software – the principal architect of its cloud strategy – with Red Hat’s CEO becoming IBM’s president. Someone who understood its strengths and weaknesses was judged better prepared to bring change.

But, although the stock reached $153 early last February, it was hit to $95 by March’s reaction to Covid-19 and has recovered more modestly than tech-leaders in focus. A price of $132 was reached early in June, then it dipped below $120. However, the positive reaction after last night’s close around $126 should see it trade over $130 this afternoon. 

Against IBM’s circa 37% recovery however, Microsoft for example has leapt 56% to an all-time high. It’s unclear whether that now represents more risk than reward in its market value. One US portfolio manager has quipped:

“It’s like one of those Jenga games where the ones at top are the most top-heavy, and if something changes that’s not expected, it could have it all fall down.”

Hurt by Covid-19 albeit gross margin improvements

Consensus for IBM’s second-quarter results had been for a 32.5% like-for-like fall in EPS to $2.07, on like-for-like revenue 7.6% down at $17.71 billion. Whether reflecting conservative guidance, the numbers have come out at $2.18 and $18.12 respectively, with net income slumping 46% to $1.36 billion. 

IBM is not providing any guidance. Moreover, the CEO cites “economic recovery looking longer and more protracted than we might have hoped for back in March”. I think that is a realistic view, despite falling short of market consensus for a V-shaped recovery. The CFO cites weakness from smaller clients, especially as capital expenditure gets cut in support of operating costs; hence, projects are deferred which has affected demand both for software and services.

Like-for-like revenue for the Global Technology Services side is therefore down about 8% at $6.32 billion. Cloud and Cognitive Software is up 3% to $5.75 billion, within which Red Hat eased from 18% growth in the first quarter to 17% based on $1.09 billion. Global Business Services eased 7% to $3.89 billion.

The combination of Red Hat, and a focus on productivity and scaling the cloud side meant a 160-basis-point rise (1.6%) in IBM’s gross margin, which contributed to £2.3 billion free cash flow.

Management sweetens its narrative in the earnings call

Despite short-term challenges, the environment is said to present opportunities as clients accelerate their shift to “hybrid cloud” and artificial intelligence (AI). Over the first quarter, cloud revenues grew 10% as clients modernise apps and move greater workload to the cloud. Although they speak as yet of increased “opportunity” of large transformational projects “that take time to shape and therefore to close.” 

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Only some 20% of client workloads are said to have moved to cloud, “the other 80% are far more difficult to move (but) there is a massive opportunity in from of us to capture these workloads”. They are entertaining jam tomorrow, partly to bolster sentiment against quite insipid second quarter numbers.

In fairness, the Red Hat Linux architecture is a market leader, and OpenShift helps operate the platform. Also, “the family of cloud packs we introduced in the second half of last year allows our middleware to run in a cloud-native environment and bridge our clients from the past to the future.”

Strong balance sheet context enables dividend rise 

End-June cash was over $14 billion, up around 60% this year, versus around $65 billion debt where global credit facilities have been renewed, of which $15 billion remains undrawn. Such cash generation has helped the quarterly payout edge up to $1.63 where assuming stability implies a material 5.2% prospective yield.

Together with a modest PE multiple of around 10x, I believe this constitutes more attractive risk/reward than US tech leaders on seemingly euphoric valuations, making them vulnerable to the slightest upset in underlying narrative, or if sentiment switches more generally in the US stock market. Around the $130 level, my stance remains: Buy.

Meanwhile, US consumer confidence is on a knife-edge

The “flash,” or estimated US consumer confidence figures for July, are just lately shown below June’s number. In a context of soaring Covid-19 infections, it will therefore be critical to see how the US death rate evolves in the weeks ahead, given potential to shock consumers and investors alike. 

More positively, if those infected make a recovery, then consumer confidence could stabilise, thereby helping a substantially services-oriented economy. This would add grist to those who claim US equities are in a new bull market since March’s low.

Currently, the dilemma is the “R” re-infection rate being over 1.0 in 45 of 50 US states, accounting for 95% of GDP. Deutsche Bank has estimated people eating in US restaurants is down 60% year-on-year, whereas the same figures are actually up 5% in Germany, helped by more stringent control measures.  

If US hospitalisations and deaths rise materially, the huge stimulus measures by the Federal Reserve since end-March might be seen to have had less effective transmission to the real economy than to asset prices, hence scope for a correction.

It appears a very difficult situation in the US: a right-wing president pushing for the economy to open up further ahead of November’s election, in conflict with medical advice. Quite similarly here, the government is eager to promote more economic activity and coax consumers from our springtime shells. Hopes of a vaccine abound, but only time will tell. 

So, watch for the US health upshot as well as the UK “R” rate after the recent weeks of restrictions easing. Globally, we still appear to be in the early stage of this pandemic.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.