Investors have given International Business Machines (NYSE:IBM) stock another chance. A market-wide selloff and IBM’s return to declining revenue sent International Business Machines stock to a nine-year low in December. Since then, IBM stock price has bounced about 36%.
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But investors’ patience won’t last forever. IBM needs to start showing real, consistent growth, and its Q3 earnings on Wednesday afternoon would be a great place to start.
If the company can convince the market that it’s a legitimate competitor in the cloud wars, IBM stock can definitely climb. Meanwhile, IBM’s largest acquisition ever closed nine days into Q3. As a result, IBM’s management will have the opportunity to detail the early performance of the company it bought, Red Hat.
As I wrote in August, I’m not convinced that the outlook of IBM stock is positive. Its business, at least in terms of revenue, has declined for most of this decade. It’s trailing in the cloud competition. The Red Hat acquisition makes sense, but it wasn’t cheap.
That said, International Business Machines stock isn’t priced for growth. Its dividend is attractive. And there’s still time for IBM to change the outlook of its shares, which have been in a consistent downtrend going back to 2013.
Its Q3 earnings are a huge opportunity for IBM to show that it’s growing again. If it does so, investors can become more confident in International Business Machines stock. But, at least for now, IBM remains a “show me” story.
Earnings Can Boost IBM Stock Price
IBM has, quite simply, returned to its old ways. Its Q4 2017 results mercifully ended a streak of 22 consecutive quarters of declining year-over-year revenue.
Two more quarters of growth followed, but IBM couldn’t keep the momentum going. For the last four quarters, the company’s sales have fallen YoY, and the Street expects the streak to reach five on Wednesday.
Those declines don’t mean IBM stock should be sold. In fact, including dividends, International Business Machines stock actually has provided a positive return over the past year (even if that return is about 1%). But IBM needs to start growing again, excluding acquisitions, at some point for the stock to rally.
I don’t think the company grew, excluding acquisitions, in Q3. But if management can inspire confidence that a positive turning point is coming, IBM stock price could climb.
Is International Business Machines Stock Undervalued Because of Its Cloud Business?
Two key aspects of IBM’s business can inspire that confidence. The first is its cloud unit.
IBM isn’t a leader in cloud platforms. Amazon.com (NASDAQ:AMZN), thanks to the runaway success of its Amazon Web Services business, is clearly in first place. Microsoft’s (NASDAQ:MSFT) Azure unit is in second place.
But IBM probably is better off than some investors might think. It’s likely fighting with Alphabet (NASDAQ:GOOG,NASDAQ:GOOGL) for third place. And Red Hat should help on that front, given its expertise in hybrid cloud.
Other companies’ cloud units have tremendously boosted their valuations. One analyst estimated that AWS could be worth half a billion dollars. A GOOG stock bull valued Alphabet’s cloud business at $225 billion.
As Bloomberg noted, even the latter figure is twice the market cap of IBM – and well above its enterprise value. The revenue of the two companies is likely similar at the moment, and the bullish Deutsche Bank analyst estimated that Google’s cloud unit could generate $38 billion of revenue in 2025 That’s roughly double IBM’s 2018 cloud revenue – which continues to grow.
So it’s possible to assert that IBM’s cloud business can meaningfully boost IBM stock. But there’s one catch. Google and Amazon aren’t losing on-premise-computing revenue amid the shift to cloud computing. The growth of the cloud is entirely positive for them.
In contrast, IBM’s efforts are causing its revenue from its legacy storage products to drop. That’s a key reason why its overall revenue is falling despite the solid growth of its key businesses.
But IBM’s cloud business won’t move IBM stock price higher unless its performance improves. Over the last 12 months, its cloud revenue has increased 8%, excluding currency fluctuations. That isn’t enough to boost International Business Machines stock. And so investors will watch closely to see if that growth accelerated in Q3.
Returns From Red Hat
IBM’s comments about Red Hat will also be closely examined. Red Hat’s revenue was growing in the high-teen-percentage levels, excluding currency fluctuations, before it was acquired. It needs to maintain that growth under IBM’s ownership, for two reasons.
First, acquisitions always are fraught with risk. They usually look great on paper, though IBM stock did fall 7% in the two sessions after the deal was announced last October. (But a plunging stock market likely didn’t help IBM stock price.) In practice, integrating acquisitions is always dicey. After Red Hat’s CFO was summarily dismissed this week, albeit due to a violation of “workplace standards,” investors will want to be reassured that the merger is progressing according to plan.
Second, Red Hat is a huge part of the company’s cloud strategy. IBM already has transitioned its software portfolio to run on Red Hat’s OpenShift. IBM did not buy Red Hat to have another asset. The deal is an integral part of IBM’s strategy going forward and a huge component of its plan to get its revenue growing again.
And IBM stock at this point, essentially, is a bet on that plan. Trading at 10.5 times its forward earnings, IBM stock is priced for basically zero growth. For most of this decade, that’s been about right. For International Business Machines stock to rise, the company needs to change those expectations. A strong Q3 report and some good news on the cloud front would be important first steps.
As of this writing, Vince Martin has no positions in any securities mentioned.