The U.S. presidential election this year is unprecedented in many ways, and the results could spark a big move in the stock market in the subsequent days and weeks. Or they may not. There’s little point in trying to guess what the markets will do in the short term. Nobody knows.
Whether Donald Trump wins a second term or Joe Biden becomes president-elect, the basics of successful long-term investing won’t change. Buy good companies at reasonable prices and hold on tight. That’s it.
We can argue about what constitutes a good company, or what price is reasonable, or how long is long enough. If you’re a value investor, you likely put an emphasis on paying the right price. If that describes you, then International Business Machines (NYSE:IBM) might be right up your alley.
A beaten-down cloud and AI play
IBM has had the unenviable task of transforming itself from a legacy IT provider to a cloud computing giant. It’s been a years-long process, and the stock has not fared well. Since peaking in 2013, shares of IBM are down nearly 50%.
Today, IBM is laser-focused on hybrid cloud computing and artificial intelligence. The company paid $34 billion for Red Hat last year, the software company behind a popular variant of enterprise Linux and the OpenShift container platform. And this year, IBM announced the planned spin-off of its managed infrastructure business. IBM will say goodbye to about $19 billion of annual revenue, but also to a business that isn’t growing and carries a far lower profit margin than what will remain under the IBM umbrella.
The leaner IBM that will emerge from the spin-off will be going after what it sees as a $1 trillion opportunity in hybrid cloud computing. IBM expects its large enterprise and government customers to favor a hybrid cloud approach, mixing on-premises hardware with public cloud infrastructure, instead of going all-in on public cloud. IBM claims that its clients are seeing hybrid cloud deliver 2.5 times more value than a public cloud-only approach.
Right now, more than half of IBM’s revenue comes from services. After the spin-off, the bulk will be derived from higher-value software and solutions. And about half of IBM’s total revenue will be recurring in nature.
Getting rid of the managed infrastructure business will remove an anchor that’s been weighing down IBM’s results. During the third quarter, even as the pandemic hurt sales, IBM grew its cloud business by 19%. Revenue from Red Hat was up 17% on a normalized basis.
The bottom line will take a sizable hit this year because of the pandemic, and there’s a lot of uncertainty going forward. Analysts are expecting profits to rebound in 2021, and the stock trades for just about 10 times the average estimate for that year. On top of the beaten-down valuation, IBM sports a dividend yield of around 5.8%.
IBM expects the spin-off, which will allow it to invest more heavily in growth areas, to lead to “…an enhanced financial profile with a clear trajectory for improved revenue and profit growth.” If IBM can pull it off and produce consistent growth after the deal is completed toward the end of 2021, then the stock will certainly deserve a higher earnings multiple.
There’s no doubt IBM has been a losing stock over the past 7 years. The company’s turnaround has been a glacially slow process, and growth has been sporadic and inconsistent. It’s not surprising that investors have largely ignored the stock in favor of other tech giants.
But all of that could change if a leaner, hybrid cloud-focused IBM can produce the kind of growth that has been sorely lacking for nearly a decade. If IBM can change the narrative, bargain hunting investors buying the stock today could be handsomely rewarded in the coming years.