MSFT - Not Your Father's IBM: The New Version Is A Winner

Summary

• International Business Machines Corporation acquired Red Hat in 2018, which has become its cornerstone of growth in the last 3 years and should continue to drive growth in the future.
• IBM's 3 businesses, Software, Consulting, and Infrastructure, complement each other and fit into a cohesive whole, giving it a tremendous edge over its competitors.
• The Hybrid Cloud market, IBM's sweet spot will continue to be a growth catalyst in the next decade.
• IBM outperformed the S&P 500 handily in Annus Horribilis 2022. There is a strong need for a steady grower in uncertain times.
• IBM deserves a much better valuation going forward based on the high quality of its sustainable and recurring earnings.

A Forgotten Stalwart

International Business Machines Corporation ( IBM ) had fallen on hard times for over a decade, divesting unprofitable and non-strategic businesses to focus on business segments with more long term potential.

Ten Years back, IBM commanded a price in excess of $200 per share, had revenues of $102Bn, operating income of $23Bn, and sported a market cap of $240Bn - all of which have dwindled in the last ten years. In 2021, sales had fallen to $57 Bn (after the Kyndryl divestment), operating income stood at $5.8Bn and its market cap today has dwindled to $128Bn. Once the Tech Titan, it now pales in comparison with Apple ( AAPL ), Microsoft ( MSFT ), Alphabet ( GOOG ), and Amazon ( AMZN )

More than a decade ago, IBM started a series of divestments with the sale of its personal computing division to Lenovo. It continued to divest more business to focus on software, consulting and the cloud, even selling its low margin, managed infrastructure business, Kyndryl in 2021, and its Watson health assets business in 2022.

My thesis is that the much leaner IBM with Red Hat at its helm and a core hybrid cloud strategy is a much stronger company poised for far greater things. I believe that even with several missteps and the loss of faith from investors including Warren Buffett, who invested and then quit after a few years, IBM has a shot at growing and becoming a profitable investment in the next decade.

Investment Case

The Hybrid Cloud Strategy is a huge competitive advantage

IBM had 3,800 clients on their hybrid cloud platform as of December 31, 2021, which was an increase of more than 1,000 clients compared to the prior year.

From IBM's 2021 10K, "According to a recent survey by The Harris Poll, 77% of businesses surveyed said they have adopted hybrid cloud for their organizations with data located across multiple clouds on-premise or at the edge." 94 percent of the Fortune 50 use IBM Cloud.

This strategy has legs, as it plays directly to IBM's strengths of skilled software support for clients who cannot rely on pure cloud infrastructure, specially in Finance. IBM's huge reach, brand name and presence in 150 countries definitely give it an edge over pure-play cloud providers such as Amazon and Microsoft. IBM has spent decades in enterprise product and service rollouts, and I believe they will continue to grow this advantage. I also believe that this space has a lot of room for growth because of security and compliance requirements, and the need for customization. That plays to IBM's advantage as it's difficult to find a provider that can meet those challenges across verticals.

Read more IBM's hybrid cloud strategy in detail here , from a fellow contributor who feels the same way.

Hybrid Cloud across IBM's Revenue Segments

After restructuring, to better reflect continuing operations, IBM started showing the importance of the Hybrid Cloud business. While the main segments of Software, Consulting and Infrastructure have not changed meaningfully in the last 3 years, Red Hat and Hybrid Cloud have moved centerstage and really transformed the company growing double digits as reported and closer to 20% in 2022 in constant currency. As a result, Hybrid Cloud now takes up 38% of revenues as compared to 31% in 2020 - across all segments.

Finally, a cohesive vision and strategy

Acquiring Red Hat in 2018 turned out to be a masterstroke, even if it cost IBM $34Bn. It laid out the groundwork for a cohesive vision and strategy, something it had been lacking for a decade. Red Hat is really the cornerstone of the new IBM. More than 94 percent of the Fortune 500 use Red Hat products and solutions. It is the fastest-growing business and galvanizes growth across all segments. I think Hybrid Cloud has helped IBM as much as the cloud business has helped Amazon and Microsoft. Buying Red Hat and leveraging its strengths as an open ended source platform with support from IBM's consulting team to focus on hybrid cloud was a masterstroke. For a while, even after selling its several businesses, it didn't look like IBM would go anywhere. Warren Buffett lost his patience within 2 years, and Buffett normally buys with 20-30 year horizons.

IBM leverages its software and Red Hat platforms to utilize its consulting segment profitably. From the IBM 2021 10K.

IBM Consulting, with 150,000+ professionals in over 150+ countries, helps clients design their digital transformation, build open hybrid cloud architectures, orchestrate applications across environments, and optimize key workflows and business processes. 100 percent of top ten companies in financial services, telecoms, public sector, automotive and healthcare are clients. IBM Consulting has more Red Hat OpenShift certified experts than any of our competition and drove about 700 Red Hat engagements in 2021. IBM Consulting has re-designed its services practices to foster adoption of our hybrid cloud platform and has built or migrated hybrid cloud applications for more than 500 clients. IBM Consulting works with our hybrid cloud and AI ecosystem partners and developers to create the custom solutions that realize digital transformation for clients worldwide, across industries. IBM Consulting also captures growth by investing in advanced practices with AWS, Azure, and major ISVs, such as Adobe, Oracle, SAP and Salesforce.

Essentially, because of the complementary nature of the three businesses, IBM uses its full stack capabilities across software, consulting and infrastructure to deliver 20% growth in hybrid cloud revenue over the last year to over $22 billion. This is the going to be its moat - even as Microsoft, Alphabet and Amazon get better with their cloud business, they don't have the enterprise and consulting experience that IBM does.

Picking a Cloud Veteran to lead the company

I think picking an IBM veteran like Arvind Krishna and especially someone from cloud was one of the best executive decisions IBM has made in a long time. Sure, Microsoft wrote the playbook on this one, but Krishna, too, brings pride back to the IBM corridors with some of their recent successes.

The Mainframe Segment is still relevant

The mainframe market is not dead, especially for banks. Structurally, this market is not likely to end up in Siberia, even as local and cloud computing take over a vast majority of software installations. Even if this grows in the low single-digits or not at all, this is an annuity and fulfills a niche nobody else can. From IBM's 2021 10K. "For example, 90 percent of the top 50 banks run on IBM Z, our Mainframe solution." Also Mainframe revenues increase every few years as clients upgrade.

Divesting Kyndryl and still retaining value

Even after divesting it, IBM has kept a commercial relationship with Kyndryl, where more than half the revenue is recurring - an annuity driven by software, and likely to continue growing.

Challenges

Sales cycles are long in all of its business segments. In a more difficult or recessionary environment, this will lead to lumpier quarters as clients stretch their dollars and budgets.

The whole idea of IBM restructuring and reorganizing its business was to divest unprofitable, slow growing divisions and those who didn't fit into IBM's strategic vision. However, this has not resulted in better operating margins. IBM still has bloated SG&A expenses of 35% of sales, up from 22% in 2012. It's not that fixed costs have gone up - it has actually dropped from $22Bn to $19Bn - the revenue base has shrunk, which result in net margins from continuing operations of only 8.2%, a huge drop from the 17% of 2012. Almost defeating the purpose of the decade-long restructuring...

However, on a positive note, there is a lot of room for improvement here, and if IBM can cut some of the flab, this will help boost the bottom line going forward. Also with a cleaner income statement, clear of restructuring and divestments there is further potential to improve margins.

Valuation and Conclusion

I am kicking myself for not buying this around $130, when I was researching Infosys ( INFY ), a company I bought and wrote about.

The biggest reason for finally investing is that IBM has a cohesive strategy in place. It is a great one, leveraging Red Hat in a red hot cloud infrastructure space, and providing massive opportunities for all of IBM's strengths and capabilities in consulting, infrastructure, and transaction processing.

There are no other companies that have IBM's resources of product/software from Red Hat, software implementation, roll out and support, software and project customization in hybrid (cloud and on premise) environments, and the brand recognition in 150 countries. I think that's a huge competitive advantage that will pay dividends for years to come.

This strategy has already returned 8% to investors, handily beating the S&P 500 (SP500), which dropped 20% in 2022. IBM was one of the few stocks to beat the market last year.

I expect IBM's revenues to grow 6% per year over the next four years as they continue to gain traction in hybrid cloud and expand their footprint. I also believe that they will continue to grow operating margins - as fixed SG&A costs spread over higher revenues, which should lead to faster earnings growth of 10%. Also these are conservative estimates -- IBM lost approximately 7% of reported revenues because of the stronger dollar in 2022. IBM gets about 60% of revenues outside the U.S., and this will be a tailwind 2023 onwards.

IBM trades at only 14X 23 earnings , much lower than Microsoft (25), Infosys (24), and Wipro ( WIT ) (19). While Infosys and Wipro grow much faster, their revenues are project based and not recurring. Even though IBM is a single-digit grower, 50% of its revenues are recurring, which make it high quality and sustainable and a huge bargain.

IBM stock can easily double in 5-6 years, returning 12-14% a year, plus a dividend yield at current prices of 4.5%. What's not to like?

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