IBM: Downgrading To Hold, No Near-Term Catalyst This Year

We're downgrading International Business Machines Corporation (NYSE:IBM) to a hold. IBM is many decades old and has gone through multiple cycles, with the latest being a shift to cloud computing after the $34B acquisition of Red Hat a few years back in 2019. IBM operates to integrate tech and expertise and provide infrastructure, software, and consulting services for customers undergoing a digital transformation. We like IBM's position in the cloud computing market and are increasingly constructive on management's shift in focus to cloud computing and A.I., but we think the A.I. hype is premature given the muted IT spend in 2H23 and limited cloud capex.

We think it'll be more difficult for IBM to re-accelerate top line growth in the back end of the year; we've already seen top line acceleration slow significantly in H1FY23, with revenue falling below consensus in 1Q23 and 2Q23. Our downgrade is driven by our belief that IBM's two core segments, software, and consulting, accounting for 42% and 31% of total sales, respectively, will face increased pressure in the near term due to the weaker global IT spending environment. In 2Q23, software revenue was up slightly by 8%, while consulting was up by 6%; we expect both segments to remain in the single-digit Y/Y growth range in H2FY23. Additionally, we see more downside from IBM's infrastructure segment, down 14% Y/Y in 2Q23.

Management's outlook for FY23 confirms the weaker spending outlook, guiding for low-single-digit top-line growth of 3-5%. We think macro uncertainty will continue to weigh on the stock in 2H23 and don't expect A.I. growth exposure to drive financial outperformance in the near term.

The following graph outlines IBM's stock performance YTD against the S&P 500.

More near-term downside risk than upside

IBM is among the largest cloud computing providers after Microsoft (MSFT), Amazon (AMZN), Alphabet (GOOG) (GOOGL), and Alibaba (BABA). We think IBM's competitive edge is improving and are constructive on management's outlook for free cash flow for FY23 at $10.5B, ahead of estimates at $9.7B. We believe the company is uniquely positioned to outperform in the mid-to-long run but don't believe IBM will be immune to the uncertain macro environment in the near term.

We don't think the slower single-digit growth outlook for IBM's main segments is due to any shortcomings from the company itself but rather the result of cloud spending nudging down QoQ this year due to customers trimming budgets in response to the higher interest rate environment. We recommend investors stay on the sidelines for the near term as we don't see a favorable risk-reward profile for the stock.

Valuation

We think IBM is undervalued on both a P/E and EV/Sales ratio. On a P/E basis, the stock is trading at 14.0x C2024 EPS $10.07 compared to the peer group average at 25.2x. The stock is currently trading at 2.6x EV/C2024 Sales versus the peer group average at 5.5x. Although IBM is currently undervalued, we believe there's no clear near-term catalyst to increase top line growth.

The below outlines IBM's valuation against the peer group average.

Word on Wall Street

Wall Street shares our sentiment of staying on the sidelines in the near term. Currently, 12 analysts are hold-rated, two are sell-rated, and six are buy-rated. The stock currently trades at $141. Using the median sell-side price target of $145, we calculate a 3% upside, and with the mean of $146, we get a 4% upside. The below better explains Wall Street's sentiment on the stock.

What to do with the stock

We're downgrading IBM stock to a hold. The shares are flat YTD, underperforming the S&P 500 (SP500) by 11%. We see a less favorable risk-reward profile for IBM in the near term despite signs of its competitive edge in cloud computing and A.I. improving into 2024. We see no near-term catalyst offsetting the softer spending environment and believe investor money can be better placed elsewhere.

Our investing group, Tech Contrarians, discussed this idea in more depth alongside the broader industry and macro trends. We cover the tech industry from the industry-first approach, sifting through market noise to capture outperformers. 

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