IBM: Long-Term Potential With AI (Rating Upgrade)

Investment Thesis

Over the last couple of months, since I covered International Business Machines (NYSE:IBM), my views on the company changed slightly to be more bullish. I believe that the AI potential is significant for the company, which will materialize in the long run. This made me change my conservative stance on the company to a more positive view, and I'm upgrading the company to a buy from a hold.

AI Presents Massive Potential

The company’s decision to focus on enterprise AI rather than consumer AI is going to deliver great results in the end. I feel like if the company wanted to get into consumer-facing AI it already missed the boat on that, so the company should focus on what it knows best, which is enterprise.

The company has been innovating in the AI space for many years already, and with the release of watsonx, the company is solidifying itself as the leader in enterprise AI, which will pay handsomely in the end. IBM is a pioneer in this segment and is innovating continuously, which in the next couple of years should translate into a formidable moat and customer growth. Recognition from reputable websites like Gartner will put IBM at an advantage when it comes to which consulting company enterprises should go with, and being recognized as the leader in Enterprise AI once again, IBM is in a great position.

In my opinion, consumer-facing AI saw a massive boom in the last couple of months because it was such an exciting new avenue, which drove massive sales numbers. Consumer-facing AI will always be around, and it has the advantage of having a larger total addressable market than enterprise AI, however, I think that enterprise AI will yield higher revenue numbers in the long run. Enterprises have a lot more money to throw at companies like IBM to make their companies more efficient and profitable in the long run. IBM's expertise in enterprise will be one of the main reasons that clients will choose the company's solutions on how to make their businesses more efficient through the deployment of AI.

The company’s AI is still in its infancy even after many years of dabbling in AI, and the next decade will show the company's prowess with next-level revenue catalysts that are not present as of right now. The advantage in the future is that AI will help enterprises become much more energy and cost efficient. This is going to be true for its customers and the company alike. In only two more years, we will see such improvements implemented according to the company’s roadmap.

The company is pioneering enterprise AI which will yield fantastic results in the end since the company missed the boat (or didn’t care for) on consumer-facing AI. It will be able to build a strong moat in the enterprise space. The global AI market is going to grow at a whopping 37.3% through 2030, and I'm sure IBM, being one of the pioneers in space, will be able to grab a good chunk of that growth.

Risks To The Thesis

The company’s innovations aren’t attracting more clients in the future and the company continues to chug along with very little revenue growth. IBM’s revenues have not performed very well, and if the innovations in AI are not going to bear fruit, the company’s potential will be squandered and will not attract many investors.

The costs of the new projects in the AI space may present some temporary setbacks, which will lead to further margin deterioration, and the share price will follow.

The competition in AI is fierce, with many companies competing to be the leaders, from small companies to large enterprises like Amazon (AMZN), Alphabet (GOOG) (GOOGL) and Meta Platforms (META). All have billions of dollars to throw into AI technology to be the dominant player in the space, and if IBM drops the ball, it will lose market share to other players.

The company’s debt levels may deter many investors. I know quite a few people who looked at the company’s debt and dismissed it straight away, however, it’s not an issue for me since it looks manageable. (I covered the financials of the company including the debt in more detail in my previous article.)

A macroeconomic risk also will play a role in the short run. Inflation is much stickier than anyone predicted, which means that the Fed may raise interest rates slightly more and keep them higher for longer. This will no doubt bring further volatility in the stock markets and potentially a better entry point.

Valuation

Quite a lot has changed since my last article on the company. I went ahead and updated my valuation analysis to reflect how I feel about the company at this point. It will still be more on the conservative end of things as that will provide a little more margin of safety in the end.

I decided to focus my valuation on margin improvements due to advancement in AI, rather than growth in revenues. This way I get even more margin of safety if I downplay the company’s revenue potential.

For the base case revenue growth, I went with 3.5% over the next 10 years, which means that AI isn't going to boost the company's revenue potential. For the optimistic case, I went with 5.5% and for the conservative, I went with 1.5% to get a range of possible outcomes.

For EPS growth, analysts are seeing the company’s growth in EPS will be around 5% for FY23 and will be around $9.57 a share. As I mentioned I will still be a little on the conservative side, I went with $7.6 a share of earnings in FY23 and will grow at around 7% CAGR over the next decade, which will bring EPS to around $13.6 a share by FY32, which doesn’t look like a massive improvement. With the advancements in AI, IBM may see a lot of efficiencies developing in its operations, which means that revenue growth isn’t always necessary if a company can increase value through efficiencies.

I also will add another 15% margin of safety to the calculation just to be on the safer side. With that said, IBM’s intrinsic value is around $150 a share, which implies that the company is trading at a slight discount.

Closing Comments

So, it looks like I was too conservative previously and didn't see the potential that AI will have in the next decade for the company. Focusing on enterprise solutions means that the company has a lot of expertise in how to execute the innovations of AI and how to implement them so that the clients will be happy in the end and continue their relationship with IBM.

I will be opening a small position relatively soon as I believe the potential in the long run is there. It would be even better if the company would start to pay down the massive debt it has - as that is deterring many investors, but as I said earlier, this doesn't concern me that much. The company is going to report earnings later in the month, which will bring quite a bit of volatility, so I may wait until the company reports before I decide to open a position.

It seems like enterprise applications of AI aren't very popular with the general crowd, which translated into rather subpar returns when compared to other AI players in the stock markets. I believe that in the long run, the company's expertise in the enterprise will benefit investors greatly.