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Here's Why IBM's Recent Analyst Upgrade Is Warranted

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Better late than never: IBM (NYSE: IBM) was the beneficiary of a recent upgrade from an analyst at RBC Capital, based in part on expectations that Big Blue's "strategic imperatives" and related solutions will gain even more traction this year.

For those who might be wondering what took so long, analysts generally look just 12 months out when determining a stock's price target and issuing a buy or sell rating. And while the upgrade to "outperform" is nice, it's the reasoning behind the bullishness that really strikes a positive chord.

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Rounding second and heading to third

In addition to the rating upgrade, RBC Capital analyst Amit Daryanani also raised IBM's price target from its "sector perform" price of $160 to its "outperform" target of $180 by the end of the year, citing a "depressed valuation" and "potential for revenue and margin stability."

The result of the upgrade was a 5% jump in stock price in the days following the news on Jan. 3. But there's still plenty of time to get on board with the stock, given its anemic valuation. At just 11.5 times forward earnings, IBM and its 3.7% dividend yield make for an extremely attractive growth and income alternative.

So what changed RBC's mind? IBM is working on several strategic imperatives, including the cloud, analytics, data security, cognitive computing, and mobile -- but it's also dominant in the mainframe market. The timing of mainframe cycle peaks should work in IBM's favor in the next couple of quarters, which in turn will give ancillary systems revenue a boost.

Accordingly, IBM's quarterly gross margin is expected to stabilize in the coming year -- not altogether surprising, since its margin declines have already lessened considerably in the past year. Revenue losses have also narrowed over the past several quarters, and cloud and related hybrid market spending are expected to improve in 2018.

Last quarter was a good example of IBM's continued steps in the right direction. Much has been made of IBM's five-year string of quarterly revenue declines, but last period's $19.2 billion was essentially flat year over year. RBC Capital's research indicates an appreciation of global currencies against the dollar, which will also give IBM sales a nudge, since it generates more than half its revenue outside the United States.

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Image source: Getty Images.

The writing on the wall

In addition to consistently narrowing its top-line revenue declines, there are a number of other indicators that IBM has been making strides in its transition. The all-important strategic imperatives, as well as its blockchain and quantum-computing initiatives , have become a larger part of IBM's total sales with each passing quarter.

The $8.8 billion in combined strategic-imperatives revenue made up 46% of IBM's total sales, and the annual cloud run rate of $15.8 billion places IBM in rarefied air among cloud providers. Microsoft (NASDAQ: MSFT) offers its cloud platform to customers as a base for its software-as-a-service (SaaS) solutions, just as IBM does. At an annual run-rate of $20.4 billion last quarter and with growth across all of its SaaS offerings, Microsoft is one of the few cloud providers that can match, let alone top, IBM.

Again last quarter, each of IBM's strategic-imperatives segments reported year-over-year growth, led by a whopping 51% increase in data security sales. However, other than cloud sales, IBM doesn't break out specific strategic-imperatives segment revenue. As for cloud-related sales, the 20% increase in revenue to $4.1 billion IBM reported last quarter was awfully impressive.

Even as it grows in critical areas, IBM is quietly becoming a more efficiently run company. In the first nine months of 2017, IBM shaved 8% off its operating expenses, to $18.4 billion.

While it's been only a few days, the near-term sell-off that we usually see following a rating upgrade-induced stock-price jump hasn't happened to IBM. That suggests it wasn't simply profit-seekers looking for a quick point or two that drove IBM's stock price up. Rather, it appears long-term investors got an IBM wake-up call from RBC Capital, which is a call every growth and income investor should take.

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Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool's board of directors. LinkedIn is owned by Microsoft. Tim Brugger has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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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