IBM undervalued with a huge hybrid cloud opportunity

IBM is a technology titan which has begun to evolve its business model to compete in the modern IT world. The company is now poised to benefit from huge growth trends across AI and the Hybrid Cloud. According to market research commissioned by IBM, 77% of IT decision-makers have adopted a “hybrid cloud” strategy. Other independent studies also back up this statistic. Later in this post, I will define exactly what the “hybrid cloud” is and its adoption benefits. For now, all you need to know is the market to forecast to grow at a rapid 21.06% compounded annual growth rate [CAGR] up until 2026. In this post I’m going to break down IBM’s business model, financials, and valuation, let’s dive in.

Business Model
The Old IBM
IBM was founded in 1911 and was a pioneer of the computing industry. Its mainframe computers had a dominant market share. However, this was disrupted by the personal computing market, which IBM didn’t take seriously enough.

Many in the computing industry feared IBM, but Bill Gates of Microsoft saw them as a partner initially. In the 1980s, IBM asked Gates if he could develop an operating system to run on the IBM personal computer. Gates bought prebuilt software and adapted it to the IBM PC. Bill Gates then made a strategic move that would be a game changer for Microsoft and sent IBM into the abyss. He insisted IBM pay a licensing fee for MS-DOS on its PCs, this meant as IBM sold PCs, it effectively acted as a “rocket booster” to Microsoft.

When the dust settled, IBM was still overly focused on its mainframe PCs. Microsoft licensed its operating system software to many manufacturers, which further increased competition in the industry.

The New IBM
IBM is currently going through a period of reinvention and has now taken a “platform approach” to its business model. One service the company offers is cloud “infrastructure as a service [IaaS]”. This basically provides virtual computing, storage, and databases. This market is dominated by companies such as AWS, Azure, and Google cloud. IBM had just 4% market share in the second quarter of 2022, and thus is a niche player. However, the company has found traction as a hybrid private cloud service. The hybrid cloud basically involves the usage of a combination of cloud infrastructure providers (AWS, Azure, Google Cloud) and on-premise IT, as opposed to just moving all IT workloads to a single platform. Hybrid cloud is popular because many enterprises don’t want to be locked into a single cloud provider and also may have data residency requirements.

In 2019, IBM acquired the Red Hat Hybrid Cloud platform, for $34 billion. This acquisition gave IBM access to a large open-source software community and enabled its customers to easily build custom software applications for the cloud. For example, if a larger enterprise wanted to keep certain customer data onsite, for data residency requirements they could set this up easily. In addition, IBM has leveraged its trusted brand to offer consulting in areas such as Digital Transformation, Hybrid cloud, and much more. Moving a large organization to the cloud is a major challenge, and thus having a trusted partner makes a lot of sense. The cloud is a huge market opportunity and although IBM may be late, it does have an opportunity thanks to its niche offering.

IBM has positioned itself as a specialist in artificial intelligence [AI], blockchain, and internet of things-based workloads. AI is a huge opportunity, given the industry is forecasted to grow at a rapid 20.1% compounded annual growth rate and be worth $1.39 trillion by 2029. IBM has its strong roots in AI, given its supercomputer, Deep Blue, beat a Chess grandmaster in 1997. Then we have IBM Watson which is a suite of AI technologies that uses machine learning algorithms to analyze vast amounts of data. This has multiple applications from language translation to speech recognition and predictive analytics. Moving forward IBM’s AI strategy is to focus on providing a “foundational model” to enterprises which can then be fine-tuned for a specific set of tasks. Recently the AI-powered foundational model ChatGPT by the Open AI institute has gone viral and created excitement in the industry. This technology has even been seen as a potential disruptor to Google search. IBM has over 40,000 patents which offer passive royalty income and protection for some of its most advanced technology.

Third Quarter Financials
IBM reported strong financial results for the third quarter of 2022. Revenue was $14.11 billion, which beat analyst estimates by $557 million and grew by 6.62% year over year. Its revenue growth rate has slowed down relative to prior quarters with 9.82% reported in the second quarter of 2022. This slower growth has been partially impacted by a strong U.S. dollar, which drove a $1.1 billion or 8% headwind. However, this was partially offset by a 5% contribution from Kyndryl. In 2021, IBM spun off the managed infrastructure as a service business Kyndryl, so it could focus on more Hybrid Cloud and AI. This was a solid move in my eyes, as it has freed up Kyndryl to finally score partnerships with the major cloud infrastructure providers. This includes Microsoft Azure in November 2021, Google Cloud in December 2021 and AWS in February 2022. Kyndryl has also been able to move faster and has developed a series of new services across security and intelligent automation.

Breaking revenue down by segment, Software revenue increased by 14% year over year to $5.8 billion. This included an 8% contribution from Kyndryl as IBM has still kept its “commercial relationship”. Transaction processing performed strongly with a rapid 33% revenue growth year over year. Approximately 80% of IBM’s annual software revenue is recurring, which is a strong positive overall.

Red Hat was a strong revenue contributor as it grew by 18% year over year. IBM has continually reported increasing deal sizes, which is a result of the strong upsell and cross-sell opportunities offered by Red Hat.

Red Hat recently announced a key partnership with Dell, to offer a series of “containerized solutions”. Containers are poised to replace traditional software virtualization as they effectively are packages that contain everything a software program needs to run. Containers have many benefits from faster deployment to easier troubleshooting. According to studies by Gartner and others, 90% of organizations are forecasted to be running containerized applications by 2026.

Automation revenue grew by slither, up 3% year over year. While its Data & AI products grew sales by 4% year over year. This was driven by IBM’s “data fabric” which is utilized to help break down siloed data in organizations and unlock its true power. IBM has been a pioneer in the data quality industry and originally developed the “data fabric” solution for its own business. The company is now a Gartner magic quadrant leader in data quality and has huge growth potential in this industry. The Big Data industry was valued at $162.6 billion in 2021 and is forecasted to grow at a solid 11% compounded annual growth rate, reaching $272.4 billion by 2026.

IBM also reported steady growth in its security products, which increased sales by 6% year over year. This was driven by the adoption of its Guardium Insights, data security platform. According to a study by McKinsey, the cybersecurity industry is a rapidly growing sector and is forecasted to be a $2 trillion market opportunity in the future.

IBM’s Consulting segment also reported solid revenue of $4.7 billion, which increased by 16% year over year. This was driven by its Red Hat consulting practice and a number of strategic partnerships. This segment can be further divided into Business transformation consulting, which increased by 16% year over year. This is driven by helping clients adopt cloud-native software packages such as Salesforce (CRM), SAP and Adobe (ADBE). In addition, technology consulting increased revenue by 17% year over year. Application operations also grew revenue by 17% year over year. IBM monitors its client’s I.T environments with an AI-powered dashboard which helps to predict issues and enable rapid remediation.

IBM’s infrastructure segment reported solid revenue of $3.4 billion which increased by 23% year over year. 9 points of this growth were from sales to Kyndryl. Hybrid Infrastructure was a key driver with revenue up 41% year over year, as more organizations adopt the hybrid cloud model.

Profitability and Cash Flow
IBM reported non-GAAP earnings per share of $1.81, which beat analyst estimates by $0.01. The company expanded its operating margin by 180 basis points, which was driven by a move towards higher-margin software products. IBM is “eating its own cooking”, by utilizing AI and automation to improve the efficiency of its own operations, which should help to boost long-term profitability. The company also operates a hedging program for certain currencies to mitigate fluctuations, although this does show up in the income and expenses.

IBM reported a free cash flow of $4.1 billion, which increased by $900 million year over year. The company has continued to operate a strong growth-by-acquisition strategy and has invested over $1 billion in acquisitions over the trailing three quarters. IBM tends to attract many traditional income investors as the company pays a healthy dividend of 4.66%.

IBM has $9.569 billion in cash and short-term investments on its balance sheet, which is solid. However, it does have a large amount of debt which totals $53.8 billion, which is up over the prior quarter but down $1 billion since December 2021. The majority of IBM’s debt, $44.78 billion, is also long-term debt and thus manageable. However, this could still be a risk if interest rates continue to rise.

Advanced Valuation
In order to value IBM, I have plugged the latest financials into my advanced valuation model which uses the discounted cash flow method of valuation. I have forecasted 6% revenue growth for next year which is aligned with the current year’s growth rate and takes into account the macroeconomic uncertainty. However, in years 2 to 5, I have forecasted 9% revenue growth rate per year based on hybrid cloud tailwinds.

To increase the accuracy of the valuation, I have capitalized R&D expenses, which has lifted net income. In addition, I have forecasted a target pretax operating margin of 23% in 10 years, which is average for the software industry. I forecast this to be driven by increased adoption and upsells of RedHat’s cloud platform.

Given these factors I get a fair value of $164 per share, the stock is trading at $142 per share at the time of writing and thus is ~14% undervalued.

As an extra datapoint, IBM trades at a price to sales ratio = 2.11, which is 26% higher than its 5-year average. However, IBM does trade at a cheaper PS ratio than other players in the technology industry such as Oracle (ORCL), PS = 4.37, and SAP which has a PS ratio = 3.6.

Risks
High Debt
As mentioned prior, IBM has extremely high debt equating to $53.8 billion. This could be a risk, given the rising interest rate environment which could cause a surge in debt servicing costs. I noted previously that the majority of this is “long-term debt”, usually due in greater than two years’ time. A low-interest rate environment is not guaranteed longer term.

Branding/Competition
IBM is attacking all the right markets with huge growth opportunities in each. My issue is IBM always seems to be playing catch-up as opposed to being a leader, for example in areas such as Cloud infrastructure. However, I believe the company has an opportunity in the hybrid cloud market and with Red Hat, but it needs to focus and tailor its messaging. SeekingAlpha