Here's How IBM Expects to Grow

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Century-old tech giant International Business Machines (NYSE: IBM) returned to revenue growth in the fourth quarter of last year, putting an end to a five-year streak of declines. This turnaround was driven by the launch of a new mainframe system and double-digit growth in the company's "strategic imperative" businesses, which include cloud computing and security.

IBM held its annual investor briefing event last week, providing shareholders with long-term financial goals. The headline numbers didn't change from last year, but IBM gave some additional details on how it expects to hit those targets. Here's what investors need to know.

The big picture

Instead of trotting out targets tied to a specific year in the future, IBM provided a "longer-term model" with no time frame attached. That's probably a smart move given how badly the company fell short the last time it tried to get too specific with its outlook. Back in 2010, IBM called for adjusted earnings per share of $20 by 2015. The company eventually abandoned that goal in 2014, and it generated adjusted EPS of just $13.80 last year.

The company's transformation has involved heavy investments in areas including cloud computing and artificial intelligence. This has knocked down profits, but it's also put IBM in a stronger competitive position. A carved-in-stone profit target provides little flexibility. IBM isn't making that mistake again.

The longer-term model calls for low single-digit revenue growth, mid-single-digit pre-tax income growth, and high single-digit earnings-per-share growth. About 70%-80% of free cash flow is expected to be returned to shareholders each year, with annual dividend increases and continued share buybacks on tap. The company expects to reduce its share count by roughly 2% annually.

What will drive this growth?

IBM's strategic imperatives will be responsible for offsetting decreases in the legacy portion of the business. In 2017, strategic imperative revenue jumped 11% year over year and accounted for 46% of total revenue. But total revenue still slumped by 1%.

Its growth strategy revolves around its cloud business and, more specifically, its as-a-service business. IBM expects its as-a-service run rate to grow by 15% to 20% annually, with added scale boosting the as-a-service gross margin by 3 percentage points each year. The as-a-service run rate reached $10.3 billion at the end of 2017.

On top of the margin expansion driven by growth in the as-a-service business, IBM expects the profitability of its services businesses to improve. IBM sees both its technology services and cloud platforms segment and its global business services segment producing 50 basis points of margin expansion annually. Workforce rebalancing will be part of the equation as IBM continues to bring on employees with the necessary skills. About 50% of all its employees were added in the past five years, partly through acquisitions.

Share buybacks will provide a couple extra percentage points of per-share earnings growth, layering on top of the margin expansion and bringing the company's total annual EPS growth up to the high single digits -- assuming all goes according to plan.

A new phase of the transformation

IBM isn't slowing down on investing in growth areas. It will continue to build out its cloud and as-a-service businesses, with "steady investment" in capital expenses part of its longer-term model. The company also expects to make more acquisitions. Over the past six years, between research and development spending, capital expenditures, and acquisitions, IBM has invested $71 billion, with $37 billion of that total having come in the past three years alone.

2018 will mark the start of those investments paying off in a visible way, with revenue growth returning and margin expansion expected. IBM's results will be choppy year to year -- it expects flat adjusted EPS this year, for example, thanks in part to a higher expected tax rate. But most of the numbers should start moving in the right direction.

IBM's growth is never going to match the highfliers of the tech industry. But with the stock trading for just 11.5 times adjusted earnings, it doesn't need to in order for IBM to be a solid long-term investment.

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Timothy Green owns shares of IBM. The Motley Fool is short shares of IBM. The Motley Fool has a disclosure policy .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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