IBM: Misunderstood Growth Strategy (NYSE:IBM) (2024)

At a targeted growth rate in the mid-single digits after the NewCo spin-off, investors could earn annualized returns in the mid-teens over the next 5 years if IBM (NYSE:IBM) can deliver on its growth initiatives. Success in CEO Arvind Krishna's focus areas, hybrid cloud and AI, are vital to that growth, but while the strategy shift provides many opportunities, it also brings risks which are not suitable for all investors.

Breaking Down IBM's Growth Strategy

CEO Arvind Krishna has made it clear that IBM's focus is on revenue growth and the cash flow needed to fuel that growth. The only surprising thing about this strategy is it wasn't the focus under Mr. Krishna's predecessor. In the past, IBM didn't "consider overall revenue growth or share price performance to be determinants of performance compensation", so while the shift may seem obvious and mundane, it is significant, as is the strategy for achieving that growth.

Hybrid Cloud & Artificial Intelligence

Investors in IBM have been told that the next big thing is just around the corner for almost a decade, so when CEO Krishna laid out a strategy using the nebulous terms "cloud" and "AI" it was met with skepticism as buzzwords to hide the lack of a strategy. I'll specifically criticize the lack of clarity later, but it is worth noting that the two areas do form a singular, cohesive strategy that target an ongoing shift in the IT space that has been accelerated by the pandemic. IBM was unfortunately not prepared to capitalize and must play catch up. Standalone AI offerings could exist, but I'll start by describing the hybrid cloud as it's likely pivotal to IBM's success in the AI space as well.

Hybrid Cloud

A hybrid cloud is just a combination of computing resources not owned by you and available for use by others (public cloud) and computing resources owned by you and generally not accessible to others (private cloud). The table below summarizes the differences between public and private clouds with the advantages italicized:

Because the public cloud is relatively new, many companies already have private cloud infrastructure that is well maintained and cheap. It may also have application specific configurations that the company would like to continue utilizing. Regardless of the reasons, many large companies want the advantages of both public and private services which is where the hybrid cloud comes in. Krishna's primary vision for IBM in the hybrid cloud space is to have Red Hat Linux with Kubernetes form a popular architecture that connects the public and private cloud in the same way that many corporations already choose Red Hat Linux as an operating system for data processing. As public cloud utilization grows, hybrid cloud opportunities should appear. In theory, a company could choose AWS for its public cloud, have another third party manage its private cloud, and then have IBM connect the two, but because many public cloud providers offer hybrid architecture, why would the company bring in IBM to introduce potential incompatibilities. The IBM strategy is three-fold:

1. Utilize an open source base functional with all/most public cloud providers giving companies the ability to switch providers if desired.
2. Strengthen its own public cloud offering, both through in-house development and acquisitions to expand capabilities
3. Create a compelling AI offering that augments the value of IBM's hybrid cloud and vice versa.

Artificial Intelligence

In some ways AI, machine learning, deep learning have become buzzwords that conjure up movie imagery of humanoid robots and supercomputing overlords. In reality the term AI is often used to describe what is technically an expert system, but without getting lost in the details, it may be helpful for investors to think of AI simply as data analysis software. Companies make huge investments in their employees to train them to understand their data and perform analysis. The average employee will only stay in the role for 2-5 years before moving on, so just as that person is getting good, someone new steps in. The promise of AI in this context is to teach a computer to analyze repetitive data sets without the risk of human error or the cost of a salary + benefits. If an example helps to clarify the point, imagine an airline trying to orchestrate planes, flight crews and catering services across all its destinations all day every day, with flight delays caused by unpredictable mechanical problems and inclement weather. This situation represents an enormous amount of data that even in the hands of the most experienced analysts is likely to be solved for in a sub-optimal manner. AI could be well suited to the task of optimally deploying the airline's resources with its constantly changing needs without having to program every individual possibility in advance. The value proposition increases if the airline already uses IBM as its hybrid cloud provider and can easily share data using a public cloud to perform resource matching while keeping passenger information safe on a private cloud.

Quantum Computing

Quantum Computing is a further down the road growth initiative, but IBM is definitely a leader with plans to build a 1000-plus qubit quantum computer by 2023. Quantum computers have limited applications right now, but by the end of the decade, they could, for certain tasks, provide game changing speeds. Due to the requirements, personal quantum computers are unlikely for some time, so they could be offered in a public cloud type offering with some promising applications in chemistry and simulations, not to mention some scary implications for cryptography. Given the murkiness of a potential, future quantum industry, I won't attempt to assign any value to this growth initiative today.

NewCo

To facilitate IBM's pivot towards the growth initiatives discussed above, the company will split out Managed Infrastructure Services in a tax-free spin off currently referred to as NewCo to be led by CEO Martin Schroeter. The new company is expected to have $19B in sales with a priority towards operational efficiency and cash flow generation while IBM pursues growth opportunities. Details have yet to be determined, but given the respective focuses, its possible that NewCo will shoulder proportionally more of the current dividend and debt. The split not only makes the investing decision easier for growth vs dividend investors, but it allows NewCo to be run outside the IBM umbrella with the independent management it needs. This looks like a classic "shrink-to-grow" situation as NewCo is expected to have 90,000 employees leaving behind a leaner IBM. Even with 90,000 fewer employees, IBM would still be a personnel heavy company relative to larger peers, and there's speculation that the spin-off could serve as cover for lay-offs to the tune of 20,000+.

Markets, Partnerships, & Acquisitions

CEO Krishna wants investors to think about Amazon's AWS and Microsoft's Azure more as partners than competitors, but competition is inevitable. IBM may be able to pursue a US-centric competitive advantage in sectors that require extra security or privacy like finance or government contracts. The advantage comes in the form Red Hat Linux, not necessarily known as the best version of Linux, but its reputation as the most secure and trusted. Consider the recent partnership with Palantir, which primarily provides its software to US government agencies. Palantir will be able offer its software more broadly as part of IBM's cloud and a boost from IBM's salesforce. IBM in turn strengthens its cloud offering while gaining additional in-roads towards US government contracts. With Red Hat as a foundation for IBM's Cloud/AI transformation, Mr. Krishna continues to bolster the company's value proposition through capability adding acquisitions. There were ten acquisitions, like Instana and StackRox, under his tenure as of the 4Q20 conference call. It is a potentially expensive and risky way to grow, but the strategy demonstrates that IBM is serious about growth, and the focus on cash flow should allow for the acquisitions while continuing to pay down debt and retain its Single A investment grade rating.

Catalysts

Covid Vaccine - The trend towards public cloud utilization was relatively unhampered by the pandemic as the shift requires very little person to person contact. Hybrid cloud, specifically the private portion of it, is more likely to require interaction and site visits to facilitate and troubleshoot effectively. As a covid vaccine is deployed and workplace protocols are relaxed, we could see an uptick in hybrid cloud utilization.

Red Hat + Acquisitions - With buybacks suspended and a minimal dividend increase of only 1 cent per quarter in 2020, IBM is repositioning its considerable cash flow towards growth. In many ways this began with the Red Hat acquisition, and while time will tell if IBM overpaid, it is one of the main growth drivers and is fundamental to IBM's growth strategy. The foundation of a strategy appears to be laid, but if IBM is serious about growth, there will need to be considerable investment going forward. I don't disagree that Satya Nadella's vision for Azure helped revitalize Microsoft, but that revitalization also required mountains of cash to be invested, in the neighborhood of $1 billion/month. IBM can't match that level of investment even if it cut its dividend entirely, but its smaller acquisitions continue under a focus of cash flow generation. The NewCo spin-off may be used to segregate dividend paying obligations without losing its aristocrat status, which the new CEO has so far been unwilling to abandon.

Management & Culture

It's been about 10 months since Arvind Krishna took over as CEO of IBM, and there have been some near term positives with some changes still to be desired.

Communication - It is refreshing to have a CEO at IBM that actually appears on conference calls to speak with investors, similar to Satya Nadella breaking with tradition when he took over from Steve Ballmer at Microsoft. Investors have received four consecutive quarters of results, strategy, and answers to analyst questions straight from the CEO.

Growth as the KPI - Management guided towards sustainable mid-single digit growth post-NewCo separation, and asked the audience to hold them accountable if they fail. They also guided for free cash flow of $12-$13 billion in 2022 as cash will be necessary for the investments fueling sales growth. The focus is no longer on EPS, which historically has been influenced by share buybacks, but IBM will not abandon margin or profitability metrics either.

Product & Service Quality - If IBM can't build it, they will acquire or partner for it. It's not exactly a rebrand, but with separation of NewCo, and a future with Red Hat as a cornerstone, IBM appears ready to put the cringeworthy software it has become known for behind it. On the service side, Krishna noted that the company's net promotor score was improving, and while I'm inherently suspicious that it was brought up as a metric, at least they're tracking it.

Imprecise Language - On the 4Q20 conference call, CEO Krishna stated "we see the hybrid cloud opportunity at $1 trillion dollars, with less than 25% of workloads having moved to the cloud so far." It is a big statement that's light on details, and begs quite a few unanswered questions. For instance, is that $1 trillion for IBM? Or $750 billion if we take away the 25%? What's the timeframe? Given IBM's revenue of less than $250 billion, why did the company miss out on so much? Investors know that providing cloud services is profitable, but it wasn't clear how that opportunity translates into profit for IBM investors.

Cloudy Results - With 82 uses of the word "cloud" in 4Q20 conference call and 56 uses in the accompanying slide deck, it looks like management wants investors to focus on IBM's cloud initiatives, yet I'm still looking for clarity on what's been included in the "cloud" results. For example, in FY 2020:

Source: IBM 4Q20 Earnings Slides

Cloud revenue growth of 67% is great, yet the Cloud & Cognitive Software Segment grew at 2%. I scoured the latest 10-Q filing for a methodology that determined what was included in "cloud revenue", but failed to even find a loose definition of what management might consider cloud. I worry that cloud revenue may be cherry-picked data from a segment that the company is largely basing future growth around.

Valuation

Valuation estimates are subject to many assumptions which I'll attempt to clarify, but will be dependent on IBM's ability to execute going forward.

NewCo

IBM has historically traded with a price/sales ratio near 1.5. Because NewCo primarily consists of legacy businesses focused on operational efficiency rather than growth, I'll use the historical 1.5x multiplier on expected sales of $19 billion for a market cap of $28.5 billion. The suggestion that NewCo would target and investment grade credit rating implies it could take on proportionately more debt than IBM, possibly in the neighborhood of $15 billion for an enterprise value of $43.5 billion

IBM - GBS, Systems, & Non-NewCo GTS

It's possible that global business services could grow as a result of efforts in the cloud and AI spaces, I'll take a more conservative approach and assume the benefits result in flat sales growth and apply the historical 1.5x sales multiplier for a combined $45B from both of these segments.

IBM - Cloud and Cognitive Segment

If there's growth in IBM's future, it is likely to come from this segment, but 2020 sales were relatively flat at $23.4 billion. A no growth scenario applying the same 1.5x multiplier brings this segment's valuation to $35 billion. Combing that valuation with IBM's other segments and NewCo yields a valuation of $108.5 billion, roughly in line with IBM's current market cap.

Growth

However, if strategic initiatives take hold, IBM could see significant growth, after all, RedHat did grow at 17% y/y. Management guided towards mid-single digit growth post separation, and in light of the pockets of growth, I'll look at a 6% growth rate as well as a more conservative 3%.

*Dollars in billions

Note that the valuation estimates include some major caveats. The valuation is based on sales, so increases or decreases in margins would shift these valuations up or down respectively. Because management has chosen to focus on sales growth and cash flow, but historically has been able to maintain or improve margins, I assume no change in margins at the company level. The valuation also does not assume any multiple expansion on the part of investors. Since changes in sentiment are unpredictable, I've chosen to use a 1.5x sales multiple which IBM has oscillated around since 2011.

Risks

Misidentified Opportunities - One estimate states that the global hybrid cloud market size was valued at $36,138 million in 2017, and is projected to reach $171,926 million by 2025, growing at a CAGR of 21.7% from 2018 to 2025. CEO Krishna stated during the 4Q20 conference call "we see the hybrid cloud opportunity at $1 trillion dollars." Without additional context it is hard to say whether IBM has a radically different estimate for hybrid cloud utilization, or whether the company is looking so far into the future to a point where hybrid cloud may even be obsolete. Quantum computing is another potential opportunity that IBM arguably entered too early having spent billions to not be ahead of the pack in a still undefined market. To quote Krishna from the 4Q20 conference call, "Quantum has the potential to unlock hundreds of billions of dollars of value for our clients by the end of the decade." Investors could be seriously rewarded if he's correct, but it is a bold claim on which to base a strategy with an aggressive 2023 timeline for a technology that doesn't entirely work, at least not all the time.

Competition - The estimated hybrid cloud market growth has attracted the attention of all the usual suspects: Microsoft, Google, Amazon, VMware, Rackspace, HP, Dell, Verizon, Cisco, to name a few, so IBM will face a lot of competition in a space where it is arguably not the leader in terms of reputation or resources. I discussed the mind-boggling amount Microsoft spent on Azure earlier, and IBM's debt coupled with its reluctance to abandon its dividend may mean it won't have enough cash to create or maintain a leadership position. The NewCo spin-off could factor in, but unless IBM finds a private buyer, it is hard to imagine a scenario in which NewCo tangibly impacts IBM's debt or dividend obligations for current shareholders. Fortunately, this does not have to be a winner-take-all market, and with billions of cash flow for investment and a solid reputation, focused execution from IBM could deliver results.

Failure to Execute - For all the success big US tech companies have had in the 2010s, IBM has lagged behind whether the metric is share price, sales growth, or profitability. I think it would be untrue to call Watson a failure, but it is a high profile example of one of many IBM programs that over promised and under delivered. The two businesses aren't the same, but MSFT is able to generate double the sales of IBM with fewer than half the people, hinting at a major efficiency problem. We've seen code words often used as synonyms for layoffs, and the restructuring involved in creating NewCo could facilitate that process as discussed earlier. It has been refreshing since CEO Krishna took over to not remind investors that IBM was "the leader in U.S. patents." Coupled with a focus on sales growth and cash flow, I'm seeing signs that IBM is focusing on KPIs that matter, which is an important first step.

Concluding Thoughts

If IBM can execute to deliver on CEO Krishna's sales growth and cash flow targets, a potential 14.4% investment return, not including dividends, is above long-term market averages and favorable in a low interest rate environment. A 3% growth scenario could provide investment returns in line with long-term market results once the dividend is factored in, but due to the risks of owning a single company undergoing a turnaround, the risk-reward may not be justified. With range bound sales, profits, and share price over the last decade, IBM has at least been stable, but with a new CEO and strategy, there are many opportunities and risks that did not exist before.

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