It’s official. Even as the vast majority of other tech stocks have closed 2022 in the red, the 111-year-old IBM (IBM, Financial) managed to pull off a surprising 5% gain. In fact, the only other big tech stock with a market cap above $50 billion that managed to report a positive year was VMware (VMW, Financial), which gained 2% for the year due to its agreement to be acquired by Broadcom (AVGO, Financial) for $61 billion.
If you had asked investors in the beginning of 2022 to pick one big tech name that would thrash the broader market even in the midst of an economic slowdown, rising interest rates and a tech sector selloff, chances are IBM wouldn’t have been anywhere near the top picks. Yet, Big Blue held its ground while the S&P 500 lost 19% and the likes of Amazon (AMZN, Financial), Microsoft (MSFT, Financial) and Alphabet (GOOG, Financial)(GOOGL, Financial) were down double-digits.
How did IBM manage to beat the market in 2022? Some might claim it’s due to value characteristics such as slow but steady earnings growth and undervaluation, though the company’s declining top and bottom lines and price-earnings ratio of 103 would argue otherwise.
So just what is it about IBM that the market loves? Let’s take a closer look at the company’s recent developments to see how it came out on top – and why it might be able to continue the trend in the new year.
The transformation plan is finally nearing completion
Too old, cumbersome and weighed down by legacy operations to report any sort of meaningful growth, IBM set out on a journey to transform its business a decade ago. The journey has been a long one, and investors couldn’t really be blamed for losing patience over that kind of timeframe. However, a surprising number held on, seeing as the share price hasn’t changed that much overall compared to a decade ago even as there has been a precipitous decline in the company’s bottom line.
The company’s long-term investors have watched over the years as IBM has steadily shed businesses where it had no meaningful competitive advantage. Using the cash from divestments and the earnings that were being steadily generated by legacy businesses, IBM invested in what it calls “strategic imperatives” such as cloud, artificial intelligence, internet of things and blockchain technologies.
While IBM has made some internal strides in these directions, such as Watson and IBM Cloud, it has also made important acquisitions such as Red Hat, Turbonomic and Instana. In total, IBM has acquired 59 companies over the past decade.
The long transformation plan now finally appears to be complete for the most part after IBM spun off Kyndryl Holdings (KD), its managed infrastructure unit, as its own business in late 2021. With the completion of this spinoff, the company can now say that the majority of its income comes from consulting and software.
New growth initiatives poised to take off
The new IBM is a much leaner company, but 70% of its revenue now comes from software and consulting, representing a more growth-oriented mix. Trailing 12-month revenue for hybrid cloud segment is $22.2 billion, up 15% over the year-ago number.
The hybrid cloud segment is expected to be IBM’s main growth driver going forward. According to Gartner, by 2025, about 60% of infrastructure and operations leaders will utilize at least one hybrid cloud storage architecture, compared to just 20% in 2022.
Red Hat sales were up 12% year over year in the third quarter, helping to reassure hesitant investors that the acquisition’s hefty price tag was a worthwhile investment. IBM is integrating the storage technologies from Red Hat’s OpenShift Data Foundation (ODF) as the foundation for IBM Spectrum Fusion, combining the two companies’ storage technologies for data services. This also improves IBM’s capabilities in the Kubernetes platform, which is the container-centric management software that has become the standard to deploy and operate containerized applications in the cloud.
Automation, data, AI and security were all down slightly but managed low-single-digit growth on a constant currency basis in the third quarter. These segments, especially AI and automation, could flag alongside a broader economic slowdown, but in the long run, they still represent promising sources of potential growth.
Another potential source of growth for IBM is quantum computing. The company may not mention its quantum computing operations in its earnings statements because this is still mostly in the research and development phase, but IBM is actually a global leader in quantum computing. Quantum computing is well on its way to revolutionizing technology, as it is able to solve problems that are too complex for classical computing. Additionally, quantum computing is about 158 times faster than the most advanced classical supercomputer.
Reasonable valuation when excluding short-term issues
There’s no denying that 103 is an unbelievably high price-earnings ratio for an old tech company that’s technically still in decline on both a revenue and earnings basis. However, this high valuation is in large part due to the steep GAAP loss per share of $3.54 that the company reported for its third quarter of 2022.
According to IBM’s third-quarter earnings report, “GAAP results include the impact of a one-time, non-cash pension settlement charge of $5.9 billion ($4.4 billion net of tax) related to the transfer of a portion of the company's U.S. defined benefit pension obligations and related plan assets to third party insurers.”
On a non-GAAP basis, the company reported earnings per share of $1.81, down 2% year over year.
When we take earnings estimates from Morningstar (MORN, Financial) analysts into account, the stock has a forward price-earnings ratio of 14.58, which is much more reasonable.
The GF Value chart rates IBM as fairly valued at current levels. However, it’s important to note that the GF Value is influenced by a stock’s historical prices, past valuation multiples and analysts’ estimates of future business performance. IBM’s GF Value suffers from the company currently being smaller than it was in the past.
Takeaway
All things considered, it seems like IBM has continued to gain ground in 2022 because it is a tech stock with high growth potential that is finally getting to the end of a decade-long transformation journey. What sets this stock apart from other tech growth stocks that declined this year is the fact that it began and ended the year undervalued and profitable, whereas most other tech growth stocks began and ended the year overvalued and unprofitable.
