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Fade the Rally in International Business Machines Corp. Stock

Luke Lango

Alongside the rest of the market, blue chip tech giant International Business Machines Corp. (NYSE:IBM) is in rally mode. IBM stock is up 12% over the past three months, with most of those gains coming from a big rally in the new year.

But does this run up in IBM really make sense? Has something materially changed about the IBM growth narrative that warrants a higher stock price?

No. IBM is a low-growth company with muted growth prospects. Over the next several years, its high-growth segments will start slowing, while its low-growth segments will keep dragging. Margins may improve, but not enough to supercharge earnings growth.

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Meanwhile, the valuation on IBM stock has run up to levels that historically have not been sustainable.

What’s the takeaway? Now may be a good time to fade the rally.

IBM Will Suffer from Slowing Cloud Growth

IBM feels like yesterday’s favorite tech company, and despite the company’s best efforts to modernize the business, it is still yesterday’s favorite tech company.

Bulls are excited about what IBM calls its Strategic Imperatives businesses. Those businesses include cloud (revenues +20% last quarter), security (+49%), mobile (+7%), and analytics (+5%). Overall, the Strategic Imperatives side of IBM is growing around 10% year-over-year.

But this growth will inevitably slow over the next several quarters and years.

Competitors are running past IBM’s cloud business. IBM’s cloud business is essentially the slowest growing cloud business among notable players. IBM Cloud grew at a 23% pace last quarter.

That is slower than much larger cloud players Amazon.com, Inc. (NASDAQ:AMZN) and Microsoft Corporation (NASDAQ:MSFT), who grew their cloud businesses by 42% and 64%, respectively.

It also is slower than similarly sized cloud players Alphabet Inc (NASDAQ:GOOG,NADSAQ:GOOGL) and Oracle Corporation (NYSE:ORCL), who grew their cloud businesses by 64% and 60%, respectively.

Clearly, IBM Cloud is being left in the dust. Granted, this is a secular growth market, but growth will slow meaningfully over the next several quarters and years as competitors gain market share.

Cloud is a big part of IBM’s hyper-growth Strategic Imperatives business. Consequently, Strategic Imperatives revenue growth will slow meaningfully with IBM Cloud.


IBM Valuation in Danger Zone

A slowdown in IBM’s Strategic Imperatives business is really bad news for this company, since the other 55% of IBM’s business is in secular decline and will remain so into the foreseeable future.

Overall, then, IBM’s growth prospects over the next several years are pretty muted. I maintain that this is a 0-1% revenue growth company with 0-3% earnings growth potential.

That isn’t much growth. But the valuation on IBM has run up to levels that have historically proven to be unsustainable.

Over the past five years, IBM stock has traded around 12-times trailing earnings. During that time frame, IBM’s price fell 15% while the S&P 500 rallied 90%.

In other words, 12-times trailing earnings wasn’t cheap enough to catalyze long-term share price out-performance.

Now, IBM stock trades at nearly 14-times trailing earnings, which has historically represented peak valuation. Moreover, if a 12-times multiple on muted growth prospects led to a 15% share price decline, how will IBM stock fare with a 14-times multiple on muted growth prospects?

Not well.

Bottom Line on IBM Stock

IBM is in the danger zone. General tax reform optimism is lifting all stocks in the market, but certain stocks have pushed into overvalued territory.

IBM is one such stock. It is trading at a stretched valuation considering its greatly muted growth prospects.

That is why I say fade the rally. IBM is only going down from here.

As of this writing, Luke Lango was long AMZN and GOOG.

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