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IBM Stock: Missing out on the actual AI opportunity

After the prior quarter, we warned investors not to buy into the AI hype at International Business Machines Corporation (NYSE:IBM). The tech giant has long had a leading artificial intelligence, or AI, product in Watson without producing any meaningful revenue. My investment thesis remains Neutral on the stock following another weak quarter and all signs the company isn’t really investing into the AI opportunity.

Ally Hype
IBM does a lot of headline grabbing announcements regarding AI, but the tech giant doesn’t actually do much to generate sales. Just since the start of May, IBM has these following deal announcements:

  • May 21 – IBM expands watsonx portfolio to scale AI on Amazon Web Services.
  • May 15 – Palo Alto Networks and IBM announces partnership to deliver AI-powered security offerings for customers
  • May 9 – IBM launches new Microsoft copilot capabilities amid AI push
  • May 8 – ServiceNow collabs with IBM, Microsoft to combine GenAI capabilities
  • May 8 – IBM and SAP to expand collaboration to build new gen AI capabilities

Every week, IBM has some partnership or collaboration with a major tech company to advance AI produces. The problem is that the company announced similarly deals in Q1, and AI related revenues aren’t moving the needle.

In late April, IBM reported these numbers for Q1 ’24:

  • Q1 Non-GAAP EPS of $1.68 beats by $0.09.
  • Revenue of $14.5 billion (+1.5% YoY) misses by $80 million.

The company only guided to mid-single digit revenue growth for the year. IBM revenues are running at a $60+ billion rate, but the AI related software category is only a small fraction of the business.

The Red Hat cloud business is a prime example of the struggles at the tech company. Cloud services are booming, with Microsoft (MSFT) and Google (GOOG) reporting 20% to 30% growth rates, yet the much smaller Red Hat business only grew 9%.

The GenAI business remains relatively small with backlog only in the $1 billion range per CEO Arvind Krishna on the Q1 ’24 earnings call:

Underneath that, our GenAI book of business, which is off to an extremely well start overall. Three quarters in since we announced our GenAI tech stack, watsonx last July. We have now eclipsed $1 billion book of business overall.

The company reported a GenAI backlog in the $500 million range following Q4. The backlog is growing rapidly, but the amounts are far too small to move the needle and very much tied to the consulting business with a book-to-bill growth rate of 1.15, but very little sales growth of 2% in the last quarter. In addition, IBM doesn’t provide plenty of details on the timeline of this backlog, as an extended contract period could signal a much smaller annual revenue boost.

The key software sector reported 6% revenue growth, with ARR up to nearly $14 billion for 8% growth. IBM is still only 25% related to recurring revenues due to the combined Consulting and Infrastructure business at $8.3 billion in the last quarter, while quarterly ARR is only in the $3.5 billion quarterly range.

Priced For AI Boom
IBM only traded at $125 last year. The stock has fallen back to $170, but IBM hit a high of nearly $200 on the AI boom.

Consensus analyst EPS targets don’t even forecast earnings growth hits 5% until 2025. Investors need to realize IBM missed revenue targets in the last quarter by $80 million, suggesting estimates are possibly too aggressive.

The stock still trades at 16x EPS targets for 2025, yet AI is forecast to generate limited additional growth. IBM actually trades at 3x the forecasted earnings growth rate, while 2x is considered expensive.

IBM is forecast to produce $12 billion in free cash flow this year, partly due to the lack of new investment. Net new capex during Q1 was only $0.4 billion, down $0.1 billion from last Q1.

With the massive AI opportunity, IBM should be investing aggressively in new watsonx AI products and data center functions for Red Hat, instead the company is cutting back on capex.

Over 10 years ago, IBM spent similar amounts on capex as Google and Microsoft, now the 2 tech giants spend 25x as much as IBM and the stocks are worth at least 15x. Both Google and Microsoft spent $10+ billion in quarterly capex last quarter, while IBM keeps cutting spending in the face of the massive opportunity.

Under the best-case scenario where IBM accelerates growth, the stock is already priced for the AI boom. Under the likely scenario where IBM never generates 5% annual growth due in part to the lack of investment, the stock languishes and likely falls back to the prior $125 range.

Takeaway
The key investor takeaway is that IBM has no logical reason to rally from here. The stock has the potential to fall, suggesting the Neutral rating is likely too aggressive, even with the AI hype propping up plenty of stock valuations.

IBM has all the reason to aggressively invest in AI, yet the company is standing pat. On this alone, an investor should avoid IBM stock. SeekingAlpha

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