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Take Your Time With IBM Stock as it Digests its Behemoth Linux Maker Deal

IBM (NYSE:IBM) shares have tumbled this month. Since its investor presentation on August 2, IBM stock has fallen from $146.58 a share to $134.12. Reducing its 2019 earnings guidance, IBM anticipates that the recent Red Hat acquisition will not contribute to earnings until 2021.

Take Your Time With IBM Stock as it Digests its Behemoth Linux-maker Deal

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The adjustments to earnings are due to non-cash write-downs of deferred revenue. As InvestorPlace contributor Mark Hake wrote last week, IBM has suspended its stock buyback program in order to pay for the Linux maker.

But with the Red Hat adding much needed growth, what’s the verdict with International Business Machines stock? Is there upside for long term investors? Or is there additional downside to the IBM stock price? Let’s have a closer look at why IBM stock may be a buy at today’s price.

Red Hat Adds Growth Potential

Prior to the Red Heat deal, IBM was treading water. The company released earnings on July 17. For the second quarter of 2019, revenue was down year-over-year. Sales were $19.1 billion, down from $20 billion in the prior year’s quarter. The company’s Cloud and Business Services unit saw slight growth (5% and 3% YoY, respectively), but declines in the Global Technology Services and Systems units countered this improvement. Despite this slight revenue slip, IBM managed to keep quarterly operating income steady at ~$2.8 billion.

The Red Hat deal adds a variety of growth catalysts to the International Business Machines story. For one thing, the acquisition makes IBM a bigger player in the $1 trillion cloud computing space. The deal is expected to accelerate revenue growth and improve gross margins. The deal is also very synergistic. IBM can now sell Red Hat’s suite of solutions to their existing customer base. With IBM’s global reach, the company could expand Red Hat’s business better than Red Hat would have done as an independent company.

But is this deal a guaranteed slam-dunk? In the past, IBM’s M&A activity has been focused on small bolt-on deals. At $34 billion, this acquisition is quite a large bite. The company could experience headwinds integrating Red Hat into its operations. Failing to meet investor expectations, the IBM stock price could see additional downside if the deal’s benefits take longer to realize.

With this in mind, is the risk worth the potential return? Are investors paying a premium or getting a bargain?

IBM Stock Valuation

With its weak growth over the past few years, IBM stock sells at a fairly low valuation. Shares currently trade at a forward price/earnings (forward P/E) ratio of 11.8x. The company’s trailing 12-month (TTM) enterprise value/EBITDA (EV/EBITDA) is 8.9x. Compare this to Microsoft (NASDAQ:MSFT), which trades for 26.3 times forward earnings, and an EV/EBITDA ratio of 18.4x. Oracle (NYSE:ORCL) trades for 17 times forward earnings, and an EV/EBITDA ratio of 12.4x. SAP (NYSE:SAP) trades for 40.8 times earnings, and has an EV/EBITDA ratio of 18.5x.

Comparing IBM to similar large information technology companies, it appears shares trade at a discount. With the aforementioned weak growth in mind, such a valuation is justified. But with the Red Heat deal adding growth potential, there could be substantial upside to the IBM stock price. If the company can pull it off, shares should see material appreciation in the next few years.

But is now the time to buy IBM stock? Or will investors have an opportunity to buy on subsequent dips?

There are many ways IBM stock could go lower. Enterprise IT is not like making widgets. The constantly evolving landscape makes it tough for established companies like IBM to stay relevant. The elimination of stock buybacks reduces the company’s ability to shore up earnings per share.

What if IBM decides to cut its dividend to reduce debt? The company has not cut the dividend since its early-90s turnaround. However, even with its high debt load, the company’s $12 billion in free cash flow is more than enough to support the current $6.48 per share payout. The dividend cut is a low-risk scenario, but still possible given the company’s need to reduce debt.

Bottom Line: Patience is Advised With IBM Stock

International Business Machines stock is clearly undervalued. The investment community has written off Big Blue, continuing to believe the company remains a dinosaur. With the Red Hat acquisition, IBM can prove the bears wrong, and deliver acceptable revenue growth going forward. But with IBM’s history of making stumbles, it is tough to take their investor presentations without a grain of salt. With this in mind, there could be additional downside to the IBM stock price.

In the event of additional bad news, IBM stock may be a screaming buy. If the Red Hat deal faces short-term headwinds, shares could trade at fire sale prices. Until then, keep an eye on IBM stock, but don’t bet the ranch.

As of this writing, Thomas Niel did not hold a position in any of the aforementioned securities.


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