Stock of the Week

IBM

IBM
NYSE Symbol: IBM
Industry: Software/mainframes
Price as of 6/28: $145.29

After a modest pullback to start the month of June, the major averages have rebound to all-time highs as the economy remains strong. Valuations for many sectors and stocks remain high making it tough to find good value. This week we will highlight an old blue chip, Dow component that hopefully has turned a corner on better earnings and sales. The featured stock of the week is IBM. Two years ago, IBM acquired cloud computing software firm, Red Hat for $34 billion, with the hopes modernizing the firm while transforming to higher margin software and away from mainframe and hardware sales. The transformation has been slow, but hopefully will accelerate going forward. IBM has been a great income stock for a long time with a dividend yield of 4.5%, but the transition to more software sales could give IBM shareholders better capital appreciation to go along with that great dividend.  

In the last quarter IBM reported better than expected earnings as sales inched up a percent to $17.73 billion, beating estimates. Since the acquisition of Red Hat, IBM continues to grow software sales. Total cloud revenue in the quarter rose 21% to $6.5 billion. Over the last 12 months, cloud revenue has grown 19% to $26.3 billion with Red Hat revenue up 17%. Thanks to software sales, IBM expects revenue growth for the full year with software sales now accounting for more than a third of their total business. IBM continues to make small software acquisitions including investments into Blockchain to increase mining of crypto coins and storing of records for customers.

With many stocks trading at elevated or stratospheric levels, IBM's valuations remains compelling at just 13 times this year's earnings and 12 times next year's earnings and just 1.7 times sales. Cash flow remains strong with full-year 2021 adjusted free cash flow estimates of $11 billion to $12 billion or a free cash flow yield of 8%. IBM has paid down $5.1 billion in debt this year, reducing total debt to $56.4 billion. IBM has paid down $16.6 billion in debt since closing the Red Hat acquisition in 2019. The fundamentals are all pointing in the right direction for IBM. Better software sales going forward could give the stock a better valuation more in line with the market and other Dow components. Currently, many industrial Dow components trade at much higher valuations of 18 to 20 times earnings. If IBM traded more in line with other Dow components, the stock could have 30% to 40% upside to go along with that 4.5% yield.