Quick Thoughts: IBM – Rerating After Rometty

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SEE LAST PAGE OF THIS REPORT Paul Sagawa / Tejas Raut Dessai

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Febuaray 3, 2020

Quick Thoughts: IBM – Rerating After Rometty

  • A week after IBM posted a surprisingly strong 4Q19, CEO Ginny Rometty stepped down in favor of Arvind Krishna, a 30-year Big Blue vet currently running the cognitive and cloud software biz.
  • Rometty (62) likely chose to move on now with confidence that the shift to growth businesses that she initiated will deliver sustainable growth, even as legacy businesses decline. Krishna is considered a strong, forward looking executive with tech skills that will be needed to navigate the next phase.
  • IBM has a strong and unique position in AI, blockchain, security, hybrid cloud architecture, and other growth technologies. Unlike rivals AMZN, MSFT and GOOGL, IBM focuses on bespoke vertical solutions, offering consulting services, myriad APIs and solution templates to help enterprise clients build applications.
  • RHT is a better than expected fit, adding world-class support for open source software. Sales accelerated in the quarter and former CEO Whitehurst has been elevated to a President title.
  • At a 10x forward P/E, 1.6x P/S and a 4.74 dividend yield, IBM should be attractive assuming modest growth and stable margins. We believe there is far more upside potential in this narrative than downside risk.
  • We see several strategic options for new CEO Krishna, including divesting more legacy businesses and making new acquisitions to bolster IBM’s position in the cloud, AI, blockchain, security and other opportunities.

After many months of speculation, IBM CEO Virginia Rometty announced that she would be stepping down, retaining her position as chairman but turning over direct responsibility to long-time Big Blue veteran Arvind Krishna, who had been running the company’s cognitive and cloud software business. Krishna is known as thoughtful technologist and a departure from IBM’s longstanding emphasis on sales. He takes over an organization that has been teetering on the verge of growth after a precipitous decline from a relative peak in 2012. The traditional businesses – mainframe hardware and software, x86 servers, PCs, chips, outsourcing, and consulting related to all of that – have been either divested or managed down to a much smaller but still profitable size. Their further decline is inevitable, although product cycles can occasionally bring upside to the trend.

Krishna’s focus will be on the part of IBM that has potential to grow, including the recently acquired Red Hat Software. Red Hat’s former CEO Jim Whitehurst was elevated to the title of President, the first time that the power of the CEO’s office has been diluted in that way. Krishna will need to work closely with Whitehurst to assure that what seems to have been a smooth integration thus far remains that way and that all of the employees can get behind what we expect to be a more aggressive version of Rometty’s growth focused strategy.

Exh 1: IBM Quarterly Sales Growth, Recent Past and Consensus Expectations

Assuming a successful transition, admittedly a modest risk, we see considerable upside for IBM going forward. While IBM’s technology strategy seems to tick the same boxes – AI, blockchain, security, hybrid cloud architectures, etc. – as cloud leaders Microsoft, Amazon Web Services and Google Cloud Platform, in practice its focus is very different. The cloud market is shifting away from the sophisticated internet-based businesses that were its early adopters and toward more traditional enterprises, many of whom have longstanding relationships with IBM. Moreover, these customers are asking for bespoke development on projects that IBM’s more generalized rivals are not prepared to address. The substantial consulting business and Big Blue’s close understanding of the business issues that these organizations are addressing are significant benefits. It also offers the most extensive set of pre-programmed APIs and development templates to aid in building customized vertical solutions. We believe that this is a major benefit.

This dovetails nicely with Red Hat’s service and support heavy model for helping enterprises implement open source software. This addition gives IBM a fuller solution set of proprietary and open source tools to help enterprise IT solve their business problems. It many never rival AWS or Azure for pure hosting volume, but it can differentiate itself for high value-added projects.

Cloud sales and Red Hat are now about a third of IBM’s revenue, accelerating in the fourth quarter to better than 23% growth. This is enough scale to offset the double-digit declines in the rest of IBM and should yield top line acceleration as the share of the growth businesses continues to expand. In this context, we think consensus expectations for ~2% growth in both 2020 and 2021 are overly conservative (Exhibit 1, 2). Given a forward P/E of 10x against these muted expectations and a dividend yield of nearly 5%, we see strong potential for upgrades and for the stock to re-rate to $200/share or higher. It has been a painful few years, but we think the pain may be over.

Exh 2: Snapshot of Key Financial and Valuation Metrics for IBM

Exh 3: Shifting nature of Cloud Services favors IBM’s positioning


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