Why IBM Is Worth $227?

The stock price of International Business Machines (NYSE:IBM) has been trading in a narrow range of $195 to $175 over the past year even though the NASDAQ has risen by over 25% during the same period. IBM’s lackadaisical stock performance reflects investor sentiments,which have taken a beating as the company’s revenues have been on a decline. However, the margins have improved considerably due to its focus on high margin businesses such as software and cloud services.

Currently, we estimate IBM’s share valuation to be $227, and believe that the recent efforts taken by the company will positively impact its long-term growth potential. During the recently concluded investor’s day conference, the company stressed that it was focused on big data analytics and cloud computing services. This strategy is yielding results as the company is witnessing robust growth in revenues from these initiatives. Furthermore, its middleware offerings continue to gain traction. Additionally, the company has undertaken cost cutting measures that will help it to improve its bottom-line. In this article we discuss key factors that contribute to our belief in IBM’s long-term potential.

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Revenues From Cloud Services To Bolster GTS And GBS Businesses

Cloud services are transforming business solutions globally and companies are leveraging technology to offer new and improved services across traditional and new channels. IBM has spent billions of dollars building its cloud business globally with a number of acquisitions in the past years that include Trusteer, Softlayer, Keneax, DemandTec and Sterling Commerce, etc.

According to IDC, the cloud market is poised to grow to over $100 billion in the next four years. ^[1] The research firm also predicts that SaaS will achieve a compound annual growth rate (CAGR) of 24% through 2016. ^[2] Furthermore, IDC expects the Infrastructure-as-a-Service (IaaS) market to grow from $12 billion in 2012 to over $38 billion by 2016. Gartner predicts that IaaS will achieve a compound annual growth rate (CAGR) of 41.3% through 2016. However, the total addressable market (TAM) for cloud services is estimated to be around $200 billion. ^[3]

IBM’s technology services (GTS) and global business services (GBS) divisions together make revenues of nearly $57 billion and account for 32% of its estimated value. In the past few quarters, IBM’s cloud initiative reported growth of over 70% and is the primary reason for IBM’s revenues stabilizing in its technology and global business services division. IBM projects that cloud services will generate $7 billion in revenue by 2015, but we estimate that the top line will be meaningfully higher due to the acquisitions and initiatives that IBM has undertaken in the past few years. We expect that most of the gains in GTS and GBS revenue in the future will come from growing cloud services. Currently, we forecast that GTS revenues will grow to $42 billion and GBS revenues will grow to $24 billion by the end of 2020.

IBM Leads The Middleware & Software Market

The Middleware division together with Operating Systems division is the biggest contributor to IBM’s stock value and makes up nearly 56% of our estimate. This division has witnessed robust growth in the past few years, and currently accounts for over 45% of IBM’s pretax income.

According to Gartner, IBM is a leader in application infrastructure and middleware software with 30 percent market share, nearly double that of its closest competitor. Gartner also notes that IBM leads in eight out of the 11 application infrastructure and middleware markets, and this makes it the undisputed leader for middleware software. ^[4] Many of its solutions such as WebSphere, Rational Suite, Tivoli cater to the growing markets that include mobile, social, cloud storage and security tools. We expect that the company will continue to post robust revenue growth in the future as its clients continue to favor IBM solutions for their middleware and application development needs. Currently, we project that middleware revenues will grow to $25 billion by the end of our forecast period in 2020, with new licenses contributing over $7.3 billion to it.

Restructuring To Improve Margins

In the past few quarters, the company has been restructuring low margin outsourcing contracts to boost profitability. Furthermore, the company has embarked upon a “workforce rebalancing” or job cuts to improve its profitability. This strategy yielded results as the company’s gross profit margins improved by 60 basis points to 48.6% year over year in 2013.

Most of the company’s cost cutting measures are centered on the ailing system and technology business. This division has lost close to $500 million in 2013. The company has systematically divested its non-profitable units within the hardware vertical over the past few years, and realigned its workforce to reduce costs. Recently, the company agreed to sell its x-86 server division to Lenovo for $2.3 billion. The company has taken further steps by shifting some of its employees to work at a partner company, GlobalFoundries, at its growing plant in Saratoga County. ^[5] If IBM can stem further declines in this under-performing division, margins for the company can improve significantly. Currently, we project that these efforts would improve IBM’s EBITDA margins from 2.35% in 2013 to 17% by 2020 due to these efforts.

We currently have a $227 Trefis price estimate for IBM which is about 25% higher than the current market price.

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1. Battles for Dominance – and Survival –on the 3rd Platform, December 2013, www.idc.com [↩]
2. Worldwide SaaS and Cloud Software 2012–2016 Forecast and 2011 Vendor Shares, August 2012, www.idc.com [↩]
3. Why IBM for cloud? [↩]
4. Report: IBM Named Market Share Leader in Application Infrastructure and Middleware Software for 13 Consecutive Years, April 1 2014, www.ibm.com [↩]
5. IBM to send up to 200 workers to GlobalFoundries, May 21 2014, www.dailygazette.com [↩]