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Robert Stephens, CFA
Robert Stephens, CFA
Articles (230) 

Why IBM Has Investment Potential

An evolving strategy could be a catalyst for the stock

June 24, 2019 | About:

Investment in its cloud offering could improve the financial outlook of IBM (NYSE:IBM). The company is aiming to take advantage of increasing demand for cloud-based services, while the planned acquisition of Red Hat (NYSE:RHT) could increase its differentiation versus peers. The company is also in the process of increasing its gross margin through implementing a variety of efficiency measures, while a reorganization could further increase productivity.

Although its stock price is flat in the last year, a low valuation suggests that it could offer investment appeal.

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Investing in the cloud

The company’s investment in its cloud offering could provide a competitive advantage versus rivals. IBM seems to be well placed to capitalize on a growing demand among businesses to shift mission-critical work to the cloud, while also addressing factors such as supply chain optimization and data protection.

For example, in the most recent quarter it introduced the innovative Watson Anywhere service. This makes the company’s artificial intelligence question answering machine available on-premises in addition to on any private or public cloud. It also released a cloud integration platform in the most recent quarter that provides a standard way for customers to access its multi-cloud opportunities. This should make it easier for customers to complete their cloud transformation journey for mission-critical work.

The acquisition of Red Hat is expected to further enhance the company’s cloud offering through providing greater choice and flexibility. It will allow customers to access both companies’ technology without being required to make a choice between public and private cloud. The deal is expected to close in the second half of 2019, with synergies forecast to catalyze the combined company’s financial performance over the long run.

Restructuring and efficiency

IBM’s decision in the most recent quarter to restructure its business could improve its customer offering. As part of this, it has combined its cloud and cognitive software segments. It has also combined its security services business with the security software segment. This is expected to unlock value and provide closer integration between hybrid cloud and artificial intelligence platforms in preparation for the acquisition of Red Hat.

Alongside its restructuring, the company is also seeking to improve its efficiency in order to increase gross margin. A key part of this is exiting lower value content within its Global Technology Services segment. Although this is expected to equate to lower revenue in the short run, over the long run it is forecast to improve profitability and efficiency.

The company is also increasing the implementation of artificial intelligence across its various operating segments. In the most recent quarter this led to an improvement in its expense-revenue ratio of 2 percentage points. Further productivity gains are expected as this process continues.

Threats

The company’s revenue in the most recent quarter declined 4.7% to $18.2 billion on a reported basis, with adjusted earnings per share falling 8.2% to $2.25 when compared to the same quarter of the previous year. Contributing to this was a disappointing performance in emerging markets across the Asia Pacific region, as well as a fall in mainframe sales that is expected to continue over the short run due to the cyclicality of the segment.

IBM’s sales performance was negatively impacted by a strong dollar in the most recent quarter. However, this had a positive impact on margins, since a stronger dollar generally helps expenses as a result of translation effects and the benefit of hedging contracts. For example, in the first quarter of the year currency changes reduced its year-to-year expense ratio by around 6 points. In Asia Pacific, client buying decision delays hurt its performance in the last quarter. They are not expected to further impact on its sales performance in future.

Outlook

In the next fiscal year, IBM is forecast to record a rise in earnings per share of 2%. While this is disappointing, the company’s forward price-earnings ratio of 10 suggests that investors may have factored in a sluggish pace of growth over the short term.

In the long run, the company’s investment in its cloud offering could allow it to capitalize on growing demand for its range of services.

Increased efficiency and a reorganization may mean that it is able to strengthen its position relative to industry peers.

Although its stock price may have disappointed in the last year, it seems to offer long-term investment appeal.


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