1. Company Overview – IBM, a tech behemoth losing its shine?
1.1 The “Big Blue” in a nutshell
International Business Machines Corporation (IBM), affectionately known by some as “Big Blue” is a multinational tech behemoth. The company operates across various segments, including cloud & cognitive software, global business services, global technology services, systems, and global financing. After selling its consumer computing unit to Lenovo back in 2004, the company has been focused on catering solely on enterprise clients. IBM today is a mature, profitable, but slow growing company with a US$133b market cap.
The company that created the world's first hard drives and designed computers that put the first men on the moon is now relegated to the back of our minds when we think about tech companies. With a decade of slow growth and a track record of missing out on exponential technology trends - is the company just another technological dinosaur on its slow march to extinction? Or has IBM finally developed a winning combination of solutions to turn the business around?
1.2. Breaking down IBM’s businesses
IBM is a super complex behemoth, so bear with me as we will spend a bit of time dissecting and understanding what we are actually analysing.
The company predominantly derives its US$60b revenue (latest FY) from 3 arms (Software, Consulting, Infrastructure) and a small portion from a financing business.
Ever since Arvind Krishna took over the reins as CEO in 2020, the company has sharpened its strategic focus to cover two key themes of helping enterprises to pursue Hybrid Cloud and Artificial Intelligence. The company also houses one of the largest industrial research organisations in the world with IBM Research.
1.3. IBM Software
IBM's software segment provides a wide range of products and services, including Hybrid Cloud Platforms (Red Hat) and Solutions (Automation, Data, AI, Security, and Health).
Hybrid Cloud*
*Hybrid cloud is a cloud computing environment that combines a company’s existing private cloud and public clouds (AWS/Azure/Google Cloud etc), allowing for the sharing of data and applications between the two in a secure and controlled manner. This helps businesses capitalise on the scalability of the public cloud while maintaining security for sensitive applications which can still be run on premise.
IBM has bet the house on Hybrid Cloud, and so far, it is showing early signs of it paying off. Hybrid platform and solutions ARR stands at US$13.6b for the company according to their Q2 earnings call. The company has acquired and built a strong core of hybrid cloud solutions across the value chain over the past few years ranging from the platforms required to financial operations (FinOps).
In 2019, IBM software purchased Red Hat for US$34b, which today forms a core part of their hybrid cloud offerings. Red Hat’s open-source operating systems and software enables the effective monitoring, provisioning, and containerisation of servers in such systems. RedHat OpenShift, IBM’s leading hybrid cloud containerisation platform, grew more than 30% in Q2 2023 and now has US$1.1 billion in annual recurring revenue, outpacing IBM software’s total 8% growth.
One-stop shop for AI curious Enterprises – WatsonX
With the hype surrounding AI resurging due to the mainstream adoption of large language models, it's easy to forget that IBM actually was one of the first to launch a conversational AI with Watson back in 2011. The company failed to effectively deliver on their marketing hype and was unable to find useful product market fit despite pouring money into hyperbolic marketing about the potential. The first mover advantage was squandered. Today the company and products look more primed to capitalise on this wave of interest in Enterprise AI.
It is interesting to note that out of IBM’s 2,700 patents across speech, NLP and conversational AI. around 400 were obtained in 2022.
In March 2023, IBM’s Watson Assistant was also named as a leader in the 2023 Gartner Magic Quadrant for Enterprise Conversational AI Platforms (CAIP), a standard widely respected by global IT managers and CIOs.
1.4. IBM Consulting
An often overlooked point is that IBM is a consulting giant. IBM's consulting segment provides a range of services including (i) business transformation, (ii) technology consulting and (iii) operations.
IBM’s consulting practice is highly synergistic with their core software offerings. No exact breakdown exists, but most of their projects leverage on their core suite of software products and offer IBM’s expert integration services to help their clients optimise costs and improve efficiency. The company continues to expect consulting revenue growth in the range of 6% to 8% and to expand consulting pre-tax margin by at least a point.
1.5. IBM Infrastructure
Since their move to spin off their struggling managed infrastructure business Kyndryl in 2021 into a separate entity, IBM's infrastructure segment now focuses solely on providing a range of hardware and software products, including Servers, Storage, and Networking Equipment. Infrastructure comprises two business areas – Hybrid Infrastructure and Infrastructure Support.
Hybrid Infrastructure: provides innovative physical platforms optimised for hybrid multicloud, AI, and flexible consumption. Includes the zSystems mainframe servers and Distributed Infrastructure.
Infrastructure Support: provides integrated services across hybrid clouds to maintain and improve IT infrastructure. IBM offers maintenance and support for IBM, open-source and non-IBM hardware/software.
2. Historical Performance – Minimal capital gains, but an underappreciated dividend machine
2.1. IBM’s historical stock returns can truly be described as “eh”.
The company has underperformed compared to both larger cap software providers in similar verticals (VMware) and their IT consulting counterparts (Accenture ACN, Infosys INFY). As of August 2023, the stock price has virtually been flat for the past 5 years.
Bears of IBM attribute the prolonged stagnation to IBM’s squandering of every large technological advantage it had under previous CEO Ginni Rometty. In the early 2010s, IBM had a similar share of the public cloud as AWS but eventually lost any advantage it had. As early as 2011, IBM Watson’s natural language processing machine promised to bring transformative changes to Healthcare and Medicine. The combination of hyperbolic marketing and underdelivering eventually saw IBM lose the AI advantage at the time as well.
2.2. People may overlook IBM being a dividend aristocrat
In terms of real returns (accounting for dividends), there appears to be a bit of a saving grace for them. IBM is what dividend aficionados refer to as an almost dividend aristocrat. The company has a current annualised dividend yield stands at 4.63% and has also consistently increased its dividend yield for the past 23 years. Once the company hits the benchmark of 25 years around Q2 2025, they would officially be known as one. This could be a very small catalyst due a potentially heightened interest among income/dividend investors as IBM officially joins the ranks of these elite dividend machines.
The high and consistently growing dividend however, could also come as an area of mild concern as disbursements become more taxing for the company. The company has a current dividend payout ratio (dividends per share/earnings per share) of 73.85%. It is extremely unlikely that the dividend will increase much more (maybe ~1% sort of dividend growth) without substantial earnings growth. However, If you were an investor who believes in an IBM growth story and the potential of the company, the dividend is certainly a more than welcome “kicker”.
3. Bright spots within IBM’s twin strategic growth sectors of AI and Hybrid Cloud
In this segment, we will take a closer look at IBM's twin strategic sectors of AI and Hybrid Cloud. We will also consider what holds for Quantum Computing - a heavily invested sector that has yet to produce real returns for the company.
3.1. Artificial Intelligence: Huge opportunity from scaling Generative AI for enterprises underappreciated by the market
When investors try to list AI companies today, most naturally think of generative AI leaders like OpenAI or the AI computing providers like Nvidia. Few will mention or even think of IBM as an AI company. IBM is an overlooked leader in Enterprise AI, despite not being the first name that comes to mind for investors.
In June 2023, McKinsey published an estimate that AI could add the equivalent of $2.6 trillion to $4.4 trillion annually across the 63 business use cases they analysed. The report also detailed a wilder estimate that half of today’s work activities could be automated between 2030 and 2060.
An Oxford Economics and IBM study revealed that 64% of surveyed CEOs today face significant pressure from investors, creditors, and lenders to accelerate adoption of generative AI.
Yet not all CEOs have rushed to adopt AI. Four in five executives today see at least one trust-related issue as a key blocker to generative AI adoption in their organisations. This includes concerns about cybersecurity, intellectual property (IP) rights, data privacy, explainability, ethics, and bias present in these models. The need for effective and clear regulation of the technology, coupled with effective internal governance tools becomes fundamental when experimenting with such technologies.
This trend would unquestionably favour AI products and companies with a strong track record of compliance and governance as compared to the new players. IBM’s prior experience with Watson Health also created a strong foundation for data security in the organisation. On the front of IP, IBM has recently announced that it would be joining the likes of Microsoft and Adobe in indemnifying their customers of copyright or other intellectual property claims for using its generative A.I. systems.
IBM’s Watsonx.governance* provides a unique feature set that will help enterprise IT leaders provide more transparency with their AI model usage and possibly to comply with regulations when clear guidelines emerge.
Watsonx.governance: Set to be launched in early 2024, watsonx.governance is a feature set from WatsonX from IBM that helps companies manage the risks of AI by providing tools and expertise for monitoring model effectiveness, maintenance, and compliance. This is valuable for managers in more conservative industries with less direct technology know-how, as AI can pose significant risks due to its reliance on data and the potential for bias and discrimination.
3.2. Hybrid Cloud: An effective enterprise solution
IBM has bet the house on the continued growth of Hybrid Cloud and so far, the strategy is looking fairly smart. The entire market is expected to grow at a CAGR of 20.2% and there appears to be decent headroom to grow.
A recent Harris Poll survey also found that 77% of enterprises have begun adopting a hybrid cloud architecture, which combines public and private cloud resources. Apart from keeping their secure data private, there are several reasons why hybrid cloud is becoming more popular. It allows businesses to avoid the vendor lock-in that can come with a single-cloud approach. It can also help businesses save money by only paying for the cloud resources they need.
Simultaneously, enterprises are increasingly moving in favour of enterprise open-source software away from proprietary software. A RedHat commissioned survey of 1296 enterprise IT leaders forecasted a 17% increase in companies switching to enterprise open-source solutions in the next two years due to the ability to influence new product features and an increase in familiarity with open source framework. Redhat Openshift, as the premier enterprise open-source containerisation platform with a market leading 31% market share (ahead of AWS Outpost/Microsoft Azure Arc), could see a further boost in adoption.
The continued growth and adoption of the hybrid cloud and enterprise open-source will bode well for IBM, who will continue to grow its recurring revenues from RedHat OpenShift and its hybrid cloud infrastructure as the company is primed to capture a larger portion of a growing pie.
3.3. Quantum computing: Further than you think, but increasingly be priced in by the market
QC remains in its early innings. Quantum computing (QC) has been marketed to the masses in the most hyperbolic possible way. “Break encryption standards” “revolutionise drug development”. Despite progress in QC and the exciting potential to address a wide range of problems that cannot be effectively handled today, QC remains in its early innings. Current scientific and research consensus is that scaling to enterprise levels is years or even decades away due to physical constraints in achieving fault tolerant computers.
Meaningful breakthroughs in the long-term will likely still be priced in. It appears that the vision for a computing advantage granted by quantum computers is likely decades away. It is, however, extremely important to note how a large part of investors are driven purely by narrative (see the current AI bubble). The most likely scenario appears that the market will head into a quantum computing winter, where the interest and funding for the sector dries up in the shorter term (~5 years) before meaningful breakthroughs occur and the narrative shifts.
IBM is well positioned to capitalize on this growth. The IBM Quantum research team is widely considered the leader in Quantum computing worldwide. The company also holds the highest amounts of patents and published research on Quantum computing and technologies. Later this year, the company is set to launch the IBM Condor, an industry-leading 1121 qubits Universal Quantum Computer which will be 21 times larger in quantum volume than its closest competitor Google Sycamore. IBM also has over 60 functioning quantum computers, more than the rest of the world combined.
4. Proven economic moat, stemming from an enduring enterprise brand, synergistic offerings and high switching cost
4.1. Enduring enterprise brand
There is a saying in IT that goes: “Nobody ever got fired for buying IBM”.
IBM may not be top of mind for most people when it comes to technology companies, but its brand remains associated positively among IT managers. IBM has a large and loyal customer base that is accustomed to the company's quality products and services. In 2022, the company was named a leader in 34 different G2 market report categories. The company is ultimately still a household name. Interbrand has named IBM as the 18th most valuable brand in the world in 2022, right behind Facebook.
Given the risk associated with the new technology, It's hard not to see the merit for CIOs to experiment with AI with a tried and tested enterprise brand like IBM as opposed to partnering with a newer name in the space.
4.2. Synergistic offerings make IBM the go-to choice for enterprises
IBM has a successful track record of capitalising on their software to create these “multiplier effects” for their consulting business. After the massive acquisition of Red Hat in 2019 and the Openshift software, the company created $1b of consulting revenue attributable to Red Hat in the first year alone. Red Hat related projects now account for ~$2b of IBM’s consulting revenue, which in turn drives more tangential software sales as IBM consultants make suitable recommendations for the enterprise clients.
The AI boom and WatsonX could potentially lead to a similar increase in demand for related consulting revenues for the company.
CFO Jim Cavanaugh revealed on the Q2 earnings call that AI related signings grew 50% as compared to the first quarter and that he believes it signals “early green shoots” on how IBM will continue to monetise the interest in enterprise AI. To bolster AI consulting capabilities, IBM has inaugurated a "Center of Excellence for Generative AI" within its consulting division, staffed by a team of 1,000 AI experts. These experts can work with clients to help tune and operationalize models for targeted use cases aligned to their specific business requirements.
4.3 High switching costs due to entrenched ecosystem
IBM has built up high switching costs for its customers over decades of business. Companies that rely on IBM's software, hardware, and services become locked-in and dependent on IBM's proprietary technology and expertise to run their operations. It becomes expensive and disruptive for these customers to switch away from IBM to another vendor. This is especially evident in the RedHat ecosystem, where enterprises who have already committed to RedHat Enterprise Linux will find it costly to make an OS level switch for their systems. Likewise as more enterprise users are onboarded to the WatsonX platform and develop their customer flows and interactions, it will be difficult to migrate and replicate them to another provider.
5. Financials are healthier than what the market gives IBM credit for
5.1. Concerns over IBM’s gearing are overblown
Critics of IBM point to the staggering $50b in outstanding debt and the high Debt/equity ratio as the key source of concern. This is understandable especially given the current high interest rate environment.
With the largest acquisition of IBM’s history with Red Hat, the company has seen significantly elevated leverage in 2019. However, it's important to note that the high debt ratio (long term debt/shareholders equity) is distorted largely due to the effect of holding large amounts of treasury stock on its balance sheet (a contra-equity), causing a decline in shareholders' equity of $169b. In comparison, main competitors like Accenture hold only $6b in treasury stock. If we were to take out the distortion created by treasury stock, their debt-to-equity ratio becomes a much more manageable 0.57X.
It also appears that the company is able to readily pay off the long-term debt obligations if one does an analysis of interest coverage ratio. IBM’s current interest coverage ratio of 9.7x may not put it in the same ballpark as its unlevered consulting peers (Accenture, Cognizant, Infosys) but places it ahead of pure-play software providers like VMware (6.9x) and SAP (9x).
In terms of liquidity, IBM also has a winning combination of cash on hand, strong free cash flow and access to capital which includes $10 billion of undrawn credit (one of the largest corporate credit facilities for a US company) with its A- credit rating.
5.2. Robust free cash flow yield shields IBM's dividend
Since CEO Krishna took over the reins in 2021, the company has been on a drive to improve key measures of profitability, especially its ability to generate free cash flow through its product mix. The company’s current 8% 2023E FCF yield places it comfortably above its consulting peers (Accenture: 5%), and pure-play cloud software solution providers (VMware: 5.3%). This level of profitability protects their 4.63% dividend yield.
6. Valuation - Reasonable entry price
We will attempt to value IBM via relative valuation and looking at broker consensus. Admittedly, in the interest of time, we did not build a DCF, which might have been more appropriate to capture how the various growth levers we highlighted above uniquely impact IBM.
6.1. Relative Valuation
Broadly, I have divided the comparable companies into two distinct buckets: (i) Large Cap Software companies, (ii) IT Consulting/services companies.
There are limitations in using this method. IBM is a behemoth that operates a diverse (software, consulting, infrastructure) and vertically integrated business. Not many publicly listed competitors have operations with a similar revenue mix and certainy not all at a similar scale.
In comparison to its closest large cap consulting peers such as Accenture which have approximately ~70% of its revenue concentrated in consulting, IBM appears to be undervalued in price.
A portion of the market still remembers IBM as the lower margin, hardware driven business as compared to a higher margin software and consulting company which makes up 75% of its business today. The key here for an increase in stock price could be for the market to recognise that IBM’s margins warrant a valuation comparable to that of its rivals with superior margins.
IBM’s revenue mix commands 21.25% EBITDA margins, and trades at a significantly lower 1 year forward P/E of 14.7. Infosys (15.68% EBITDA margin) and Accenture (16.98% EBITDA margin), is trading at significantly higher 20x and 25.1x 1-year forward P/E respectively.
6.2. Broker consensus
The consensus analyst average for 18 analysts put IBM at a $145 price target with a majority (11) of brokers giving a hold or neutral rating to the stock. In July 2023, JP Morgan’s North America Equity Research team rated the stock a hold and a price target of $145 And in August 2023, Zacks Research gave a $155 6-12 month price target. Since starting this deep dive, RBC initiated a buy call on 22 September 2023, with a 6-12 month price target of $188. In essence, the Street is still not very bullish on IBM's future prospects.
Except for the RBC analyst, we believe the Street is undervaluing the growth potential of IBM’s current revenue mix and its ability to convert on the current AI hype cycle. The growth in AI and hybrid cloud will continue to enable margin expansion for the firm.
We noticed that the Street is gradually becoming more bullish with IBM, so analysts re-rating in the near to mid-term may be a catalyst that drives price up. We explore other catalysts below.
7. Investment Catalysts
7.1. Extension of the AI hype cycle
Gartner’s 2023 edition of the AI hype cycle posits that Generative AI is currently in the absolute peak of inflated expectations and for this process to last for another 5-10 years.
The continued interest and development of the enterprise use cases will continue as long as companies continue to see positive return on investment through cost reductions and efficiency improvements. This ongoing trend will likely bode well for IBM as a leading enterprise AI provider.
7.2. Successful demonstration of quantum computing applications in commercial settings
A long-term catalyst could be when IBM’s dominant Quantum Computing research position translates into real economic impact and presents a real computing advantage. This will most likely not be realised in the near term as mentioned in the earlier industry outlook component.
Most cutting-edge technologies today are (unfortunately) driven purely by narrative. Should IBM be able to demonstrably feature a strong commercial application of the Quantum advantage, it is highly likely that the stock will see a short-term boost. One such example (albeit it currently being more of a PR stunt) is in the arena of pharmaceuticals research. Moderna (NASDAQ:MRNA) has recently signed an agreement with IBM in April 2023 to use technologies including quantum computing and artificial intelligence to advance mRNA research.
8. Key Risks / Where we could go wrong
8.1. Failure to deliver on Enterprise AI experience with WatsonX
As a significant gamble to grow its software revenues, IBM has bet big on its WatsonX platform. In spite of the company’s track record of innovation in Digital Transformation and AI, customers may not view IBM as an innovator relative to newer emerging technology providers in the generative AI space.
The product has reportedly been pushed to 150 global enterprise clients in Aug 2023 in their first 10 days of launch including the likes of Samsung. This number reported, however, is not a clear indication of early success as we do not fully know of the unit economics/pricing of the product to make a good estimate of the potential revenue it can bring in for the company. Should we have any new indicator of slow uptake/bad product reviews of their core AI products, we should effectively nullify/taper the AI growth thesis.
8.2. Integration Risk & Impact of Constant Acquisitions
With the slew of acquisitions by IBM, the company runs the risk of serious integration risks. The acquisition of Apptio for example, brings along 1300+ new employees in 20 offices globally. It is uncertain whether the new acquisitions may lead to cultural clashes, employee turnover, and operational inefficiencies instead of the purported synergies stemming from the product.
Constant acquisitions also increase the amount of net intangible assets on IBM’s balance sheet that may or may not translate to cash flow (assets that do not have physical substance, such as patents, trademarks, and copyright). The high total outstanding debt of IBM (~US$50b) also worsens with each acquisition, which may affect its ability to pursue new growth sectors in the future.
8.3. Recessionary environment affecting core consulting business
As consulting is ultimately a discretionary business and given the reasonable probability of a recession at the end of 2023, IBM's consulting business estimates may need to be revised downwards even further.
Key digital consulting competitor Accenture has narrowed their revenue guidance from 8-10% to 8-9% foreseeing such macro headwinds in H2 of 2023. Earnings results from Infosys, Accenture and Tata Consultancy all showed deteriorating IT spending, especially in banking and technology sectors.
9. Concluding thoughts
Should you believe in the growth narrative of hybrid cloud, the enterprise use cases of generative AI, or even the more far-fetched quantum computing advantage narrative, IBM has an incredibly strong enterprise brand with a track record of delivering value for enterprises. If the promise of AI/Quantum computing eventually disappoints or does not live up to its expectations, IBM's Consulting business will continue to gain from their respective hype cycles as businesses today remain committed to learning and experimenting with these cutting-edge (fashionable) technologies. As we await Q3 earnings results for the company, we would also look out for cues regarding the company’s ability to deliver the enterprise AI experience that it promised. It is important to note that Q3 has not historically been good for the company due to the renewal cycles of its hardware business.
IBM presents a unique, lower risk option to own a company that is selling shovels to the generative AI gold rush and a bet on the continued growth of Hybrid Cloud. IBM could be an interesting addition to your portfolio should you need a low-beta, high-dividend yield stalwart with a growth upside.
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