A Bull Case for IBM

10/31/17

Courtesy of Motley Fool

IBM (NYSE:IBM) has gotten kind of beaten down in the past few years, and more than a few analysts are bearish on the stock's prospects. However, there's plenty of indicators that the company still has a great runway for growth.

In this Industry Focus segment, Motley Fool tech writer Tim Green explains why he's bullish on IBM's long-term potential. Listen in to find out what invaluable assets IBM has, and how they give them an edge against their competition; why dividend investors should definitely have this stock on their radar; some of IBM's most promising growth areas; what risks investors need to be aware of with the company; and more.

A full transcript follows the video.

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This video was recorded on Oct. 20, 2017.

Tim Green: I'm Tim Green. I write mostly about tech stocks. I'll be talking about International Business Machines. On the surface, the IBM the story does not look very exciting. Revenue has been slumping for the past five years. Earnings are down. The cloud computing business, one of its major growth initiatives, is being overshadowed by the two market leaders, Amazon (NASDAQ:AMZN) Web Services and Microsoft Azure.

But IBM has one big advantage that I think is being overlooked. Entire industries rely on its products, and it has long-standing relationships with major organizations in nearly every country. A few examples that drive home this point: 90% of global credit card transactions are processed by an IBM mainframe, which IBM has been selling for more than 50 years. Essentially all the world's largest banks use IBM products to run their infrastructures, and four-fifths of all travel reservations go through IBM's system. Its broad base of customer has allowed IBM to generate more than $12 billion of free cash flow each year, even as it invests in new businesses that it hopes will return it to growth.

Its cloud strategy plays to this strength. IBM is focused on enterprise customers, high-value services, not simply growing revenue as fast as possible by renting commodity commuting resources. Earlier this year, IBM signed a 10-year cloud services deal worth about $1.7 billion with Lloyds Banking Group, a major U.K. bank. This will be a minor part of IBM's total revenue, but it represents exactly the kind of deal that will drive growth in IBM's cloud business. The bank is big, with over a trillion dollars of assets. It's a long-standing IBM customer, and the deal represents a brand-new revenue stream with IBM not only hosting applications in its cloud, but also managing migration of those applications.

IBM has also struck deals to build platforms based on blockchain, a distributed database technology that underlies cryptocurrencies like bitcoin. It's working with a consortium of major banks to build a blockchain-based platform for tracking international trades transactions, and it's working with foods companies like Wal-Martand Nestle to use the technology to add transparency to the global food supply chain. Just like in its cloud computing business, IBM's existing relationships with many of these companies is a valuable asset, especially when dealing with such a new and unproven technology.

None of this has helped IBM avoid a long slide in revenue, and it's hard to predict exactly when it will turn a corner. But with the stock trading for barely more than 10 times earnings guidance, I think the market is being far too pessimistic.

Dylan Lewis: I think one of the important things to note with that pitch is, we had our writers' conference last week. Tim recorded his pitch, and, actually, Danny recorded his pitch on Netflix, before both companies reported earnings. Tim's IBM pick here looks even better when you consider the market's reaction to its most recent earnings report.

Sarah Priestley: Yeah, Tim looks stellar after this. The earnings report came in, and they had a beat on earnings per share of $3.30, versus the $3.28 which was expected. Their revenue was better than expected, but still a decline for the past 22 quarters. Tim touched on that in his pitch; it continued.

Lewis: That's the thing we're constantly watching with this company: Where will the bottom be for the revenue growth? And when will they stabilize and return to growth? I think people were pretty optimistic this most recent quarter, because the decline wasn't as much as maybe they had thought, which is tough to curb into a bull case.

Priestley: Yeah, absolutely.

Lewis: But really, I think what Tim's getting at here is, this company has been struggling for quite some time, but the floor is so high for this business because they're this entrenched player, they're already installed in so many businesses, that basically, you're getting this big business turnaround play at a fairly cheap price. And he mentioned valuation a little bit there. The stock has a trailing P/E of 13.5, which is practically half of what the market is trading at right now. And that's even after they were up 10% following earnings.

Priestley: Yeah, absolutely. I think you described it before we came in: People were wondering whether they've hit the bottom of the earnings plateau, and I think that's exactly what people are expecting. And there were some highlights in their earnings. Strategic imperatives, which is their analytics, cloud, mobile, security, all of their new endeavors, grew 11% year over year, and that's 46% of their revenue, from this segment. A particular bright spot within that was cloud revenue, which grew 20%, which is actually incredible growth.

Lewis: If you read through the earnings call for this company, you see them highlighting all these different growth factors. You just mentioned a couple right there. For them to consistently struggle with growing the top line, that obviously means that part of their business is not working.

Priestley: Oh, yeah.

Lewis: What's going on there, Sarah?

Priestley: Core Technologies declined 80%. Within that, you have their technology services, which was down 3%. Global business services down 2%. A lot of this is exactly as it sounds, their legacy core infrastructure that they have established, and a lot of their long-term contracts. And part of the reason for this is, it's harder to make money than it used to be. It's harder to get those margins. Another reason is, it's just so much more competitive, and those two played together. But the other thing to note, and I'm sure you were going to touch on this, the big reason their earnings came in so well was their effective tax rate, which we were talking about yesterday.

Lewis: It was, like, sub-15%. It's crazy.

Priestley: It's 11%. It's the second-lowest tax rate in the Dow Jones. The only other company that has a lower tax rate on the Dow is GE. And the way that companies do this, as I'm sure a lot of people know, is through -- I don't want to use the word loopholes, [laughs] but it kind of is loopholes.

Lewis: Creative accounting.

Priestley: Creative accounting, yes. Kind of, transferring assets between business units, writedowns. In this case, it was transferring IP between business units.

Lewis: One of the things that Tim didn't mention with his pitch that I think is pretty important with IBM is the dividend. You look at this company -- it has raised its dividend for 22 straight years. They're just short of that 25 that you need to be a Dividend Aristocrat, which is this vaunted dividend status. If you want more on that, we have a piece, as I'm sure Michael Douglass has told pretty much every Industry Focus listener at this point.

Really, even not being a Dividend Aristocrat, IBM is one of the bankable tech dividends. And they're not going anywhere anytime soon. They're probably going to become a Dividend Aristocrat. I think they've been paying out dividend for over a hundred years; they just haven't consistently raised it long enough to be in that class.

I mention this because, to me, IBM is far more compelling as an income investment, not necessarily a growth investment. You're getting a 3.75% yield on IBM shares currently. That's not too shabby. But we talked about how they have these growths drivers that are available to them, and yet, the struggle of the core business is so much that they haven't found that floor yet. And I worry, even when we get to the point where revenue is stabilized, what is actual revenue growth going to look like? Is it going to be in the low single digits? Because, if you're looking for growth investments, I don't know that IBM is the place to do it.

Priestley: I would agree with you. I do think we shouldn't underestimate the base that IBM already has. It's a huge company. The scale is massive. Like you said, reading through the earnings report, trying to keep track of all the divisions that they have is difficult. They have this large, sticky core base of software and hardware legacy products, across 170 different companies. Just in the services business, they own 5.7% market share of this ginormous business globally, which is double the next person behind them.

I think, while we shouldn't underestimate that, I 100% agree with you. I think there are so many companies now -- Microsoft, Oracle, Amazon -- jumping on these strategic initiatives around big data and machine learning, it's going to be really hard for them to deliver the margins that they have had before.

Lewis: And it's a company where, if you're really interested in them, you have to go into it knowing what you're getting. You're going to be getting consistent dividend growth, maybe some share price appreciation now that the company has started to turn around. But with a $150 billion market cap company, it's much harder for them to double or triple the way that a smaller medium-size or small-cap company might be able to.

Priestley: Yeah, and that's one of the issues for their clients, in the sense that it's such a big, huge behemoth company that, to try and understand how each of the divisions relates to one another, what services they need, it's very complex. And I think they're probably not leveraging a lot of the opportunity that they have between inter-divisional learning that they could be.

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