IBM reported 3Q20 earnings last week that were largely in line with expectations and consistent with trends over the past few quarters.  The report came on the heels of a major announcement from the company that it will be spinning a big piece of its slow-growing business to increase concertation on its cloud and artificial intelligence businesses.  The stock has been under a lot of pressure since it initially popped 10% on the spin-off announcement and now sits at its spring and summer lows.

Immediately after the spin announcement, the shares shot up from $120 to $140.  We believe this supports our thesis that as IBM returns to modest growth there is a lot of upside in the shares.  Unfortunately, details of the spin-off indicate that the reward will be delayed.  First, the spin is unlikely to occur until the second half of 2021.  Second, the costs to separate the businesses are high on a cash basis.  As these facts were digested, IBM shares gave up most of the spin announcement gains.

The stock has taken another hard hit since reporting earnings.  Our review of the report and analyst estimates indicates little variance in the results relative to expectations.  Research has pointed to a slowdown in growth of Red Hat.  Red Hat drives the cloud transformation that makes us bullish on IBM, so this is a concern.  However, a slowdown was expected and growth remains in the mid-teens.  We think another factor at work is that several peers who are also focused on large enterprise spending, such as Cisco Systems, have seen a sharp slowdown in revenue growth.  This was not evident at IBM, but investors have soured on companies supplying technology products and services to large enterprises.  Finally, there has recently been a rotation away from high-growth winners in areas like cloud services.  Many stocks in these high-growth industries have pulled back 10% or more.  This has likely bled over to IBM given the importance of Red Hat and the cloud to returning the company to growth.

Fortunately, IBM pays a very healthy dividend while we wait for our bullish thesis to play out.  Currently, the dividend equates to an annual yield of nearly 6%.  We are disappointed with the pace at which our thesis is developing at IBM.  We never expected the stock to work right away and we certainly did not expect a pandemic to hurt traditional core business lines.  The spin-off of legacy businesses to focus on growth areas fits our thesis perfectly, so we plan to remain patient.  At just 10 times 2021 consensus earnings estimates with a 6% dividend yield, it takes little upside in the shares to produce a good total return from current levels.  We think expectations and sentiment are low, and the prospects of a slimmer, more focused, and growing new IBM can produce significant upside in the shares as we move into 2021.  We hope to see more progress soon.

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.