International Business Machines (IBM) has spent years trying to turnaround the business via a move into strategic business lines, but the tech company could never make the official turn last in the past. The recent acquisition of Red Hat has finally turned the ship as the company finally has a strong position in the cloud sector. My investment thesis remains bullish as the company hikes EPS estimates and finally ushers in a period of growth.
Image Source: IBM website
Positive Quarter For Once
The recent history of IBM has been one of over promising on strategic initiative growth and under delivering on actual results. In the process, the stock was always cheap for a reason while offering an attractive dividend yield approaching 5% on many occasions.
The Q4 quarterly report has the potential to finally offer the long awaited turnaround that will move the stock off the $140 level. The addition of the Red Hat cloud business and new leadership has the potential to cement the turnaround this year following a failed recovery in 2018.
A couple of key numbers signaling IBM is ready for the official launch of the turnaround
- Red Hat revenue was up 24% to $1.07B, first quarter topping $1 billion.
- IBM sees 2020 operating EPS of at least $13.35 and FCF of about $12.5B.
The main focus of the market will be the accelerating growth for Red Hat due to new services engagements and an expanding client base following the merger with IBM. The merger closed back in July and the Red Hat division generated Q3 growth of 20% on a constant currency basis. The revenue acceleration to 24% growth in the last quarter is very encouraging that merger synergies are boosting the potential of IBM in the booming cloud sector.
The secondary focus is the improving earnings picture as boosted by the Red Hat numbers above. IBM just completed the year earning $12.81 per share so even the analyst expectations for 2020 EPS above $13 was generally ignored by the market. The stock wouldn’t have spent the last couple of months trading below $140, if investors expected EPS to actually return to growth in 2020 and beyond following the purchase accounting hits last year.
Analysts had the company earning somewhere below $13.30 this year and the company just guided to EPS of $13.35 following the Q4 revenue beat of $160 million. IBM hadn’t beaten revenues in the last five quarters so any beat here is a big positive for the stock.
Due in large part to the accretive benefits of the Red Hat deal down the road, analysts already had the tech company earning $14.20 in 2021. Even after the after-hours boost to $145, IBM still trades for only ~10x EPS estimates for 2021 and now the market likely has more confidence in those estimates with the possibility of a further EPS boost.
One only needs to look at this Q4 table to understand the benefits of the merger. In the December quarter, revenues were only up slightly, but the gross profit jumped over $400 million. In the process, the gross margin was up 190 basis points over last Q4 to 51.0%.
Source: IBM Q4’19 earnings release
CEO Ginny Rometty has long claimed the company was on the verge of a turnaround during her tenure, but investors now know if she doesn’t deliver a new executive will take over. Red Hat CEO Jim Whitehurst is poised to become the future leader down the road as IBM shifts to the hybrid cloud. For this reason, investors can take more heart in this statement from the CEO knowing another false step only ensures a power shift in the executive suite:
Looking ahead, this positions us for sustained revenue growth in 2020 as we continue to help our clients shift their mission-critical workloads to the hybrid cloud and scale their efforts to become a cognitive enterprise.
The key investor takeaway is that the better than expected Q4 results provide more confidence IBM is finally on the track towards growth. The company has long guided towards free cash flows growing to ~$13 billion in 2021 based on the Red Hat deal and the stock isn’t going to last at a market value below $130 billion with growing cash flows at this level.
Investors can now safely buy IBM on any weakness going forward.
Looking for even more? Join DIY Value Investing.
Disclosure: I am/we are long IBM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The information contained herein is for informational purposes only. Nothing in this article should be taken as a solicitation to purchase or sell securities. Before buying or selling any stock you should do your own research and reach your own conclusion or consult a financial advisor. Investing includes risks, including loss of principal.