IBM‘s (NYSE: IBM) stock recently dipped after the tech giant posted its third-quarter numbers. Its revenue fell 2.6% year-over-year (down 3.1% excluding divestments and currency) to $17.6 billion, matching estimates but marking its third straight quarter of declining revenue. Its adjusted EPS fell 4% to $2.58 but also met expectations.
IBM cleared Wall Street’s low bar, but it didn’t attract many new investors ahead of its planned split into two companies next year. Should investors assume IBM’s stock is dead money for now, or is it still an undervalued turnaround play with a generous dividend?
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The key numbers
IBM’s core growth engine during the quarter was its Cloud and Cognitive Software unit, which houses Red Hat, its cloud services, and its AI tools. The segment’s revenue rose 7% year-over-year to $5.6 billion, led by Red Hat’s double-digit growth.
Unfortunately, all of IBM’s other businesses contracted. Its Global Business Services revenue fell 5% to $4.0 billion, due to weak software sales and project delays throughout the pandemic. Its Global Technology Services revenue declined 4% to $6.5 billion due to reduced demand for IT services in “more economically sensitive” industries. Its Systems revenue slid 15% to $1.3 billion, due to cyclically lower demand for IBM Z and Storage systems. Its Global Financing revenue declined 20% to $273 million as it wound down its OEM commercial financing business.
Image source: Getty Images.
IBM’s total cloud revenue across all its businesses rose 19% to $6.0 billion, but that marked a deceleration from its 30% cloud growth in the second quarter. Nonetheless, IBM’s gradual shift toward higher-margin services boosted its adjusted gross margin by 160 basis points year over year to 49%.
IBM generated a free cash flow of $4.8 billion in the first nine months of 2020, which declined by more than $1 billion from a year ago but still covered its $4.3 billion in dividend payments. It raised its dividend for the 25th straight year in April, making it a Dividend Aristocrat of the S&P 500, and it currently pays a forward yield of 5.7%.
IBM didn’t offer any guidance for the fourth quarter. But during the conference call, CFO Jim Kavanaugh noted that “from a historical perspective, the fourth quarter seasonally is our strongest quarter in terms of revenue and operating earnings per share due to our high-value software and hardware transactions.”
However, analysts still expect IBM’s revenue and earnings to decline by 3% and 4%, respectively, during the fourth quarter. For the full year, they expect its revenue to decline by 4% and for its earnings to drop 14%.
Dead money or a turnaround play?
The bears will point to those dismal forecasts and claim IBM is “dead money.” After all, its stock has declined nearly 20% over the past decade as it’s struggled to expand its higher-growth businesses to offset the declines in its legacy businesses.
Even after factoring in reinvested dividends, IBM delivered a total return of just over 10% as the S&P 500 soared nearly 200%. Its latest numbers suggest its weaknesses are still overwhelming its strengths, and that CEO Arvind Krishna, the former cloud chief who took the helm in April, faces a difficult uphill battle.
The bulls likely expect Krishna’s decision to split IBM into two companies to pay off. By spinning off the sluggish IT services segment of its Global Technology Services unit into a new company, the slimmed-down IBM can aggressively expand its hybrid cloud services, which fill the gap between big public cloud platforms and private clouds.
Meanwhile, the stand-alone IT services company could streamline its business and invest in its own growth instead of subsidizing IBM’s higher-growth businesses. That shift could help it compete more effectively against nimble rivals like Accenture (NYSE: ACN), which consistently outperformed IBM’s IT services segment in recent years.
In short, the two new companies could fare much better than the old IBM. Therefore, investors who buy IBM today at less than 10 times forward earnings might eventually see their value stock split into two higher-growth stocks.
I personally believe IBM will be “dead money” until it completes its split in late 2021, but its low valuation and high yield should limit its downside potential. But in 2022 and beyond, I believe the two new IBMs could become turnaround plays with more upside potential.
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