Northlake’s investment thesis on IBM centers upon the gradual transition to faster revenue growth as cloud services become a greater part of IBM’s revenue mix. Prior to the COVID crisis, we got an unexpected boost from a CEO transition that elevated the head of company’s cloud efforts.  The economic shutdown clearly will impact IBM as the large enterprises it serves will delay and cancel technology spending.  There is little IBM can do about it and we just have to accept that impact on our investment thesis.  However, we see the crisis as delaying rather than averting our thesis.  In fact, the importance of cloud services has been elevated by the crisis, enlarging the addressable market and speeding the transition.  IBM faces fierce and larger competitors in cloud including industry leaders Amazon and Microsoft.  A larger and faster growing market is good for all cloud providers and IBM’s 1Q20 results suggest its transition is on track.

The key to IBM’s move to hybrid cloud services is the company’s 2019 acquisition of Red Hat.  Red Hat allows IBM to go to its large enterprise clientele with proven, industry leading solutions.  IBM has a niche to fill as many large enterprises are not comfortable moving to the public cloud solutions offered by Amazon, Microsoft and new entrant Google.  Large enterprises, particularly in health care, government, and financial verticals want to build a hybrid cloud where data is stored both publicly and privately.  This enables greater security of sensitive data and reliable back up of all data.

1Q20 results showed Red Hat business lines growing a better than expected 20%.  The line is getting blurry as Red Hat is integrated but IBM’s overall cloud services growth enabled the company’s key growth segment to grow at better than expected low-to-mid single digits despite initial COVID pressures in March.

The company’s 1Q20 conference call went well and featured the first appearance by the company’s new CEO, Arvind Krishna.  Mr. Krishna had been leading IBM’s cloud services division and spearheaded the acquisition of Red Hat.  At the same time he was promoted, IBM named Red Hat’s founder and CEO as President or the company’s #2 executive.  Mr. Krishna made a good impression on his first earnings call. Importantly, he indicated he would be on every call going forward, which is a positive change from the prior CEO who rarely appeared on calls.  Several analysts asked if more M&A including possible divestitures of legacy businesses was possible.  Mr. Krishna indicated this was possible.  Northlake believes any future M&A that increases exposure to growth businesses like cloud and software would be well received by investors.

Earlier this week, IBM announced a tiny increase in its dividend of less than 1%.  With many companies announcing dividend cuts or suspensions due to the COVID crisis, the announcement serves to reinforce IBM’s strong financial position, a clear positive in the uncertain economic environment likely to remain in place for at least a couple of quarters.  IBM shares have a dividend yield of 5%, another attraction for Northlake and enough to allow time for our investment thesis to develop.

Prior to the economic shutdown, Northlake’s target for IBM was $173 based upon modest expansion in the company’s P-E multiple as revenue growth accelerated.  Earnings in 2020 are going to be lower than previously expected with 2021 possibly matching our original hope for 2020.  This serves to delay the timing to achieve our target but not alter it.

IBM is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts.  Steve is sole proprietor of Northlake, a registered investment advisor.  Northlake’s regulatory filings can be found at www.sec.gov.