Is IBM a Value Stock or a Value Trap?

IBM‘s (NYSE:IBM) stock price recently tumbled after the tech giant posted its fourth-quarter numbers. Its revenue dropped 6% year over year to $20.4 billion, missing estimates by $260 million and marking its fourth straight quarter of declining sales. Its adjusted earnings fell 56% to $2.07 per share, though it still beat expectations by $0.19.

IBM’s results weren’t surprising, since it’s repeatedly struggled to offset the slow growth of its legacy IT services, on-site software, and hardware businesses with its newer cloud-based businesses. However, investors were also likely expecting better results after IBM acquired Red Hat in 2019 and brought in a new CEO last year.

IBM has already been a disappointing investment over the past 10 years. Its stock lost about a quarter of its value and reinvested dividends only gave investors a total return of 3% — compared to a total return of nearly 270% for the S&P 500 over the same timeframe.

A disappointed investor takes a break from the trading screen.

Image source: Getty Images.

But despite that poor track record, the bulls still believe IBM is a value stock on the verge of a turnaround. IBM certainly looks cheap at 10 times forward earnings with a hefty forward dividend yield of 5.5% — but is it a value stock, or a value trap?

What the bulls believe about IBM

The bulls believe three catalysts will end IBM’s losing streak. First, they expect its total cloud revenue to continue rising as it expands its hybrid cloud and AI services.

READ:  Why Etsy Stock Plummeted Today

Second, they expect Red Hat’s open-source software — which plugs into a wide range of private and public cloud platforms — to strengthen its presence in hybrid cloud deployments. They believe Arvind Krishna, IBM’s new CEO who previously led its cloud and cognitive software division, can lead that transformation.

Lastly, the bulls expect IBM’s upcoming spin-off of its slower-growth managed IT services division, which should occur by the end of 2021, to free up more resources for its hybrid cloud and AI businesses. That split could also allow the IT services segment to expand as a stand-alone company that isn’t burdened with supporting IBM’s higher-growth cloud businesses.

What the bears will point out about IBM

Those strategies sound good on paper, but the bears will point out three flaws in IBM’s plans. First, IBM’s cloud growth is tepid. Its cloud and cognitive software revenue rose just 2% to $23.4 billion, or 32% of its top line, in fiscal 2020. This was the only core business segment that generated any sales growth during the year.

IBM claims its “total” cloud revenue, which includes cloud services from other segments, rose 19% to $25.1 billion. However, this metric is inflated by its acquisition of Red Hat, and obfuscated by opaque reporting methods for cloud services scattered across its legacy businesses. If you look at the growth of IBM’s six core businesses in 2020, it’s impossible to tell how its “total” cloud growth actually benefits the company:

Source: IBM.

Moreover, IBM’s entire cloud business is both smaller and growing at a slower rate than larger cloud platforms like Amazon (NASDAQ:AMZN) Web Services (AWS) and Microsoft‘s (NASDAQ:MSFT) Commercial Cloud.

Second, spinning off the managed IT services segment might not generate sustainable sales growth. Krishna believes IBM can wedge itself between private and public cloud platforms with hybrid cloud deployments, but Amazon, Microsoft, and other companies also offer similar services.

Lastly, Krishna blamed the company’s fourth-quarter sales decline on the pandemic and macro headwinds, which applied “additional pressure on larger software transactions” and caused “project delays in some services engagements.”

But we’ve heard these reasons before, and they don’t explain why other software companies — including Amazon, Microsoft, and high-growth darlings like Snowflake — remained resilient through the downturn. Even Oracle, which is undergoing a similar cloud-based transformation as IBM, generated stronger growth.

That glaring gap indicates that enterprise customers didn’t necessarily spend less money during the pandemic — they just spent less money on IBM’s services.

READ:  Earnings Roundup: Starbucks, Alphabet, Shopify

It’s still a value trap — for now

Krishna believes the “new” IBM will generate “sustainable mid-single-digit” percentage revenue growth after it completes its separation, led by the expansion of Red Hat (which generated 18% sales growth during 2020), improvements to its global business services (GBS) segment, and the integration of new hybrid cloud and AI services into its GBS ecosystem.

That outlook sounds promising, but Krishna also warned that IBM’s recovery was “not necessarily going to be a straight line.” In other words, investors should still expect weak sales growth, opaque reporting methods for its cloud business, and ugly comparisons to its industry peers for the foreseeable future.

IBM isn’t doomed yet. But in a market filled with higher-growth cloud and software plays, IBM definitely looks like a value trap instead of a value stock.


This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

View more information:

Articles in category: investing

Leave a Reply

Back to top button