Over the past two years, International Business Machines Corp. (IBM, Financial) has been the company everyone loves to hate, and it is easy to see why. The tech giant failed to keep up with the rest of the tech world’s transition to the cloud and instead continued to focus on its legacy hardware and software divisions. At the same time, lower-cost Chinese competitors have been edging in on the company’s dominance in these markets. Combined with its lack of presence in the cloud market, the company’s loss of market share has translated into multiple consecutive quarters of revenue decline.
After several years of struggling, IBM now appears to be back on track and figures are heading in the right direction.
Back on track
Even though revenue continues to decline in its legacy divisions, revenue from IBM’s four “strategic imperative” divisions -- cloud, analytics, mobile and security -- are growing at a mid-teens rate and accounted for 41% of revenue at the end of 2016. Cloud revenue for full-year 2016 jumped 35% and cloud-as-a-service run-rate revenue grew 61% year-over-year.
Even though IBM’s total revenue fell from $81.7 billion for full-year 2015 to $79.9 billion for 2016 with the growth of the “strategic imperative” divisions now reaching an inflection point, it looks as if revenue declines will come to a halt or be reversed over the next two years. Indeed, the division that was responsible for almost the entirety of the company’s revenue declines for 2016 was systems, which generated revenue of $7.7 billion in 2016, down from $9.5 billion in 2015. For the fourth quarter, systems (includes systems hardware and operating systems software) revenue declined 12.5% including currency.
To put this decline into some perspective, systems revenue declined $1.8 billion during 2016 and overall revenue declined by $1.8 billion. Strategic imperative revenue growth added around $4 billion to the top line. Considering these figures, if the company’s four strategic units can repeat their growth performance during 2017, there is a chance that IBM could return to top-line growth.
Undervalued, under loved
The above is just a simple, quick calculation, but without going into the complex web of IBM’s finances, it highlights how the company is now in a position to restart growth after several years of floundering.
If growth does not return next year, it will likely come back in 2018 as imperative revenue nears 50% of overall group sales.
IBM is forecasting for operating (non-GAAP) diluted earnings per share of at least $13.80 and GAAP diluted earnings per share of at least $11.95, disappointing as it will mark yet another year of earnings contraction. Non-GAAP diluted earnings per share, however, exclude $1.85 per share of charges for amortization of purchased intangible assets, other acquisition-related charges and retirement-related charges, which can be considered nonessential to the operating of the business. Therefore, from an operating perspective, IBM’s earnings will return to growth next year.
Based on these forecasts, IBM is trading at a forward price-earnings (P/E) ratio of 12.9 compared to the industry mean of 25.3. The shares offer a dividend yield of 3.2% and trade at a price-to-free cash flow ratio of 13.3. With a free cash flow per share of $13.3, at current prices, the shares trade at a free cash flow yield of 7.4%-- extremely attractive in the current interest rate environment.
Conclusion
All in all, using a simple analysis of IBM’s revenue and potential growth from strategic imperative divisions, as well as the company’s own forecasts, it looks as if the company is set to return to growth next year. Despite an impressive growth outlook however, the shares still trade at a relatively attractive valuation.
Disclosure: The author owns shares of IBM.
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