International Business Machines Corp. (IBM) provides a wide range of services, software, and hardware solutions across multiple industry verticals. IBM is making a push into hybrid cloud, as well as newer technologies such as artificial intelligence, machine learning, quantum computing and others. Its segments include Software, Consulting, Infrastructure and Financing.
Investment Overview
IBM’s software segment growth is mainly driven by Red Hat. IBM’s software segment, which includes Hybrid Platform solutions and transaction processing revenue, increased by 7.1% y/y in 2Q24 to USD6.7bn, led by Red Hat, which continues to grow at double-digit y/y since its acquisition in 3Q19. According to Mordor Intelligence, the global hybrid cloud market is projected to reach USD130bn in 2024 and at a CAGR of 22% over the next five years. Consensus project IBM’s software segment, which contributes more than 40% to the total revenue (in FY23), to grow at a CAGR of 5.9% over FY23-25F.
IBM’s consulting segment is exposed to heightened risk due to a deceleration in IT spending. IBM’s consulting segment is engaged in business transformation, technology consulting, and application operations. IBM expects its full-year FY24F consulting revenue to grow by a low single-digit due to the continued pressure seen on spending related to discretionary projects. According to Custom Markets Insight, the global IT consultancy service market is expected to grow at a CAGR of 6.5% over FY23-FY25F, while the street estimates IBM’s consulting segment (which accounted for 34% of FY23 revenue) to grow at a CAGR of 2.1% over FY23-25F, lower than the 8.2% growth experienced during FY21-23.
IBM's Watsonx will serve as a crucial support system for customers' AI initiatives. IBM's AI investments position the company as a trusted advisor for customers starting their AI journey. Management estimates that more than 80% of enterprises are experimenting with Large Language Models (LLMs). IBM delivered watsonx.ai (a UI for development and training of Gen AI models) and watsonx.data (a data store) into production and has received strong enthusiasm from clients. By the end of FY24F, IBM expects to acquire HashiCorp for USD6.4bn and integrate its automation technology into Red Hat, watsonx, data security, IT Automation, and Consulting. IBM raised its expectations of Software revenue growth in FY24F to high-single digits in its 2Q24 earnings release, due to early traction in GenAI and strength in the recurring revenue base, which is above consensus expectations of ~6%.
HOLD IBM with a revised TP of USD250 (prev USD200). Our TP for IBM is based on a 24x (prev 19x) 12-month forward blended net profit of USD9.9bn (prev USD9.7bn). Our higher TP is due to rolling forward of blended net profit by 3 months. We have taken a 10% discount to IBM’s software and consulting peers currently trading at a 12m forward PE of 26x. IBM currently trades at a 12m forward PE of 22x (last 5-year average at 13x). Consensus projects IBM to have an earnings CAGR of 6.3% over FY23-25F (Dec YE), compared to peers’ 11%. The current setup for the stock presents challenges due to the possibility of a global economic downturn impacting IT spending adversely.
Risks
(1) weakening IT spending due to macro concerns, especially in high-exposure segments like financial and public, (2) revenue disappointments due to slowing services, (3) increasing competition pressuring margins, and (4) declining mainframe business.
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