3 Tailwinds for IBM in 2018

1/4/18

By Timothy Green, MotleyFool

International Business Machines'(NYSE:IBM) investors had a rough 2017. The stock slumped about 7.5% in a year when the major indices posted double-digit gains. The company's turnaround efforts, while showing signs of progress, failed to produce growth through the first nine months of the year. Five years of declining revenue is a tough sell.

2018 has the potential to be quite a bit better for IBM. The company expects to produce revenue growth during the fourth quarter of 2017, and it will announce these results in January. If it can keep that momentum going, 2017 will mark the official bottom for Big Blue. Three tailwinds will help the cause this year, each contributing to IBM's return to growth.

An employee working on a z14 mainframe system.

THE Z14 MAINFRAME SYSTEM. IMAGE SOURCE: IBM.

The mainframe

Every 2 1/2 years or so, IBM launches a brand-new mainframe system. This triggers IBM's install base to upgrade, creating a spike in sales. The sales bump typically lasts for four quarters, after which sales decline as the launch is lapped. Each mainframe launch also drives sales in related businesses. Around 90% of mainframe systems are financed, so new mainframes provide a boost to financing volume. And IBM sells plenty of software and services to mainframe customers, as well.

IBM announced its latest mainframe system, the z14, in July 2017. The system began shipping near the end of the third quarter, driving a 62% year-over-year increase in mainframe sales. The fourth quarter should also see a big boost to sales, with smaller increases in the first half of 2018.

The mainframe is the main reason IBM expects to grow fourth-quarter revenue. The sales boost in the first half of 2018 won't be as big, but combined with the other tailwinds and the continued growth of IBM's "strategic imperatives," it might be enough to push total revenue higher.

POWER9

The mainframe isn't the only piece of hardware that IBM sells. The company also sells Power systems, built around its POWER processors. These servers provide an alternative to the Intel-based systems that dominate the market.

Prior to 2013, the only way to buy a system with a POWER processor was directly from IBM. This changed with the OpenPOWER foundation, a consortium of companies aiming to build an ecosystem around the POWER architecture. IBM began allowing third parties to build POWER-based systems, and it began pushing its chips for use in hyperscale data centers.

IBM announced the first system featuring its new POWER9 processor in December. The system is designed for artificial-intelligence workloads, providing a massive data throughput boost compared to Intel-based systems. These new Power systems could drive growth in IBM's Power business in 2018.

The longer-term story revolves around IBM's efforts to get its chips into data centers. Alphabet's Google announced in 2016 that it was building a server architecture based on the POWER9 processor. We should see more news on the data-center front this year, although winning market share from Intel won't be easy or quick.

Still, the new POWER9 processor and Power systems will act as another tailwind for IBM in 2018.

Currency

Around 2/3 of IBM's annual revenue is produced outside the United States. Because IBM reports its results in U.S. dollars, swings in foreign-exchange rates can lead to swings in revenue. The U.S. dollar strengthened against other currencies in 2014 and 2015, wreaking havoc on IBM's top line. During the third quarter of 2015, for example, IBM reported a whopping 14% year-over-year decline in revenue. But 9 percentage points of that decline was due to currency, with another 4 percentage points due to divested businesses.

Currency is a two-way street, so if the U.S. dollar weakens against other currencies, IBM's top line will benefit. 2017 was the worst year for the U.S. dollar since 2003, and further weakening in 2018 would provide a boost to IBM's top line. Even a small tailwind is meaningful -- a 1 percentage point benefit translates to around $800 million of additional annual reported revenue.

Revenue growth from currency isn't "real," in the sense that it's not being generated by winning additional business. But it sure makes the numbers look better at a time when the market needs some convincing that IBM's turnaround will be a success.

IBM expects to produce at least $13.80 in adjusted earnings in 2017, putting the price-to-earnings ratio at just over 11. The stock also pays a 3.9% dividend, with a 22-year record of raising that dividend. Investors have been put off by IBM's streak of revenue declines, but with 2018 shaping up to be a solid year for the tech giant, it's not too late to jump in on this bargain stock.

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