IBM Preparing For Changes Ahead

The last time I updated International Business Machines (IBM) in August 2019, I concluded that “the company must prove that it can generate more revenue from its Red Hat acquisition” for its share price to rally.

It has taken longer than I expected for that to happen, but it appears that the company may finally be proving the value of that transaction.

On April 21, IBM released fiscal 2021 Q1 results that reflected a 1% rise in total revenue. Most of the credit for that unexpected gain was due to a 17% increase in revenue from its Red Hat division.

As a result, total cloud revenue jumped 21% to $6.5 billion. On a non-GAAP (generally accepted accounting principles) basis, IBM’s per share diluted earnings of $1.77 was 4% lower on a year-over-year basis.

That day, shares of IBM rose nearly 4% and were up more than 15% since the start of the year. We’ve been down this road before; IBM staged a similar rally during the first quarter of 2019 and topped out above $150 that summer.

However, the stock market crash triggered by the outbreak of the coronavirus pandemic last year sent IBM careening below $100 before quickly rallying back above $120.

The question this time, as in the times before, is whether IBM can hold onto this gain and continue higher. I think it will, due to the company’s expanding profit margin as more of its income is derived from its highly scalable cloud and A.I. (artificial intelligence) operating units.

During the first quarter of this year, IBM’s GAAP gross profit margin expanded by 120 basis points (1.2 percentage points) to 46.3%.

Wall Street will be watching IBM closely during the run-up to the divestiture of its legacy services business later this year. At that point, the company will primarily consist of its higher-margin growth businesses, including Red Hat.

According to IBM’s CEO, Arvind Krishan, “IBM is laser-focused on the $1 trillion hybrid cloud opportunity. Client buying needs for application and infrastructure services are diverging, while adoption of our hybrid cloud platform is accelerating.”

The company is being careful not to overpromise and underdeliver, saying only that it “expects to grow revenue for the full year 2021 based on mid-April 2021 foreign exchange rates.”

That accomplishment alone would represent a significant achievement for IBM since its annual revenue has declined for the past three years. With the completion of multiple 5G telecommunications networks expected before the end of this year, the company should be aiming much higher than that in the years to come.

The problem for Wall Street right now is assigning a value to IBM as it prepares to split into two separate entities. Presumably, all of its high dividend payment will go with the legacy business into the new entity. At that time, that company will be a strong candidate for our Income Portfolio. Until then, we are raising our buy limit for IBM to $150.

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