International Business Machines (NYSE: IBM) stock recently set a new 52-week high, breaching the $150 per share level for the first time in more than a year. While its increasingly prominent role in the cloud has gained attention, it remains a company in transition.
The upcoming spinoff of its managed infrastructure services business, to be called Kyndryl, brings both opportunity and uncertainty for IBM shareholders. Given the challenges the venerable tech company faces, is its stock still a good buy?
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Hybrid cloud could be key
Since it acquired Red Hat in 2019, IBM has placed a heavy emphasis on hybrid cloud systems, which allow public and private clouds to interact more harmoniously. Peers such as Amazon's (NASDAQ: AMZN) AWS, Microsoft's (NASDAQ: MSFT) Azure, and many others compete in this space.
However, there's a lack of standardization among such systems that can limit interactions between public and private clouds. Red Hat Enterprise Linux and Red Hat OpenShift offer cloud providers a widely used code that the industry could standardize. Such a move could allow public and private clouds to interact seamlessly and securely. Since most organizations now need both cloud types, widespread adoption of such a product would give IBM's top line a boost -- and a competitive advantage over competitors.
In IBM's first-quarter earnings report, it revealed that its cloud revenue grew 21% year over year. Total revenue for the company moved higher by only 1% over the same period. Despite rising revenue, net income fell by 19%. That was because IBM had a $1.2 billion tax benefit during the first quarter of 2020.
For full-year 2020, IBM's revenue fell 5% from 2019. Nonetheless, cloud revenue surged 19% during that time. Over the last four reported quarters, free cash flow came in at $11.6 billion -- easily enough to cover 2020's $5.8 billion in dividend costs. At its current share price, its $6.56 per share annual dividend provides a yield of around 4.4%, well above the 1.4% average for the S&P 500.
IBM has partially addressed its revenue struggles via its plan to spin off Kyndryl. Revenue has consistently fallen in the division currently running Kyndryl, global technology services (GTS). However, since Kyndryl had a backlog of $60 billion when IBM announced the spinoff, it's possible that the business could benefit from a dedicated leadership team focused solely on managed infrastructure.
On the Q1 earnings call, CEO Arvind Krishna predicted that IBM will achieve revenue growth in the mid-single-digit percentages once Kyndryl becomes a separate company. This would be a significant improvement from its recently flat or declining revenues.
Critical questions linger regarding the Kyndryl spinoff
Unfortunately for IBM investors, the lengthy process of spinning off Kyndryl, which the company is expected to complete late this year, comes with significant uncertainty.
For one thing, investors have little clarity on what the financials of IBM or Kyndryl will look like once the split is finished. Management has not revealed the degree to which the business unit being hived off has affected the divisional revenue declines within GTS, nor even if it generates a profit on its own.
Questions also remain regarding the IBM side of the business. One can presume its revenue increases will improve without the relative drag of Kyndryl. However, IBM has not said to what degree its cloud business contributes to net income or free cash flow.
For now, IBM stock is trading at a price-to-earnings (P/E) ratio of 25. This compares favorably to Microsoft's 35 multiple and Amazon's 63 ratio, though investors may have to reassess the value proposition once they see the P/E ratio of the post-spinoff IBM.
The other big question involves how the two companies will split the dividend. Both will maintain a payout, and investors should rest assured that both companies will retain Dividend Aristocrat status if they continue to make annual payout hikes.
However, this maneuver could see one company picking up an outsize share of the dividend costs. That would hold significant implications for income-oriented investors, who might have reason to favor one company over the other following the separation.
Should I buy IBM?
Although I own IBM stock and intend to hold it, new investors might choose to wait rather than buy it at current levels. Although the spinoff should help IBM better capitalize on hybrid cloud growth, there are lots of unanswered questions regarding financials, dividends, and valuation.
The good news is that the answers to those questions will be revealed in time. And once they are, IBM stockholders and prospective buyers should hold the necessary information to make better investment decisions regarding the tech stock.
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