IBM reported modestly better than expected earnings against lowered, pandemic-impacted expectations.  Revenue and EPS both fell year-over-year as growth in cloud-related business lines (including Red Hat) could not overcome secular decline in legacy software and hardware business and cyclical impacts from the pandemic.  Importantly, we continue to see green shoots in IBM’s transition toward cloud computing and improved profitability.  At just 11X next 12 months earnings and sporting a 5% dividend yield and new CEO, we like the risk-reward in IBM.

Northlake’s investment thesis on IBM is that the company can return to growth driven by a mix shift in favor of cloud-based business lines.  IBM is far behind cloud leaders Amazon and Microsoft, but the Red Hat acquisition completed in 2019 is providing a growth engine on its own and especially by complimenting and tying together IBMs other cloud businesses.  IBM remains an important supplier to many large enterprises and with Red Hat is now able to lead the transition to hybrid cloud environments.  Management is firm in its belief that the just reported 34% growth in cloud-related revenues is not just moving current clients from one business line to another.  Rather the company is gaining incremental revenues.

The IBM story is not without challenges (as reflected in the depressed P-E multiple).  Unlike peers such as Oracle, IBM did not reinstate 2020 guidance.  Investors take this as a signal that management confidence is low.  Structurally, IBM still has material revenues, perhaps 40% that are in secular decline and are unlikely to ever resume growth.  Profitability has been continually challenged as leverage works against the declining businesses and thus far the successful Red Hat and cloud initiatives drive revenues but not profits.  IBM is using the pandemic to drive costs out of the business and this should become evident over the next twelve months.

Investors favor growth stocks at the moment and IBM is a value stock.  We like the set up though as should the company’s growth profile improve, the potential for multiple expansion is high.  Cisco Systems faced a similar transition a few years ago albeit with a better legacy business in networking.  Once the company returned to modest growth the P-E went from 10 to 15.  At 15X the 2021 consensus estimate, IBM would trade at $180, up 40% from current levels.  This is plenty of upside even if it only gets part of the way there and the low P-E and 5% dividend yield reduces the risk profile.  The next couple of quarters will be key to our IBM thesis.  We are happy to wait especially since Northlake has plenty of exposure to high growth darlings including Alphabet, Facebook, and Activison Blizzard.

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.