IBM (IBM - Get Report) is unjustifiably one of the cheapest companies offering cloud-based software solutions. Big Blue continues to spew out significant amounts of free cash flow, and its Q2 2019 results show that IBM continues to improve its fundamental operations.
George Soros taught us that good investing is boring. In that vein, IBM makes for a delightful investment.
IBM and Its Tightly Scripted Narrative
IBM has many issues. Nevertheless, I have been arguing since the start of the year that its stock was undervalued. Since that time, its stock is up approximately 22% compared with the S&P500 which is only up 13%. Plus, it's been offering a 4.7% dividend. So far, so good.
Now onto a pressing issue -- IBM is known as a bureaucratic machine. Accordingly, last week's highly-scripted earnings call should have come as no surprise. Investors' initial reaction was one of dismay at having no update on IBM's $34-billion acquisition of multi-cloud platform operator Red Hat.
But despite that, the lack of surprises on its earnings call, together with an extremely cheaply valued stock, and investors were happy to give IBM a pass, with its stock continuing to press forward.
What Lies Ahead?
IBM flexed its almighty balance sheet on the acquisition of Red Hat. IBM clearly and firmly pointed out that its underlying business, excluding Red Hat, continues to operate on track. On August 2, IBM will hold an investor day to update analysts and shareholders on its full-year 2019 earnings, including Red Hat.
Presently, we know that given the large amount of stock-based compensation expected from Red Hat's acquisition, that it will dilute IBM's 2019 operating earnings EPS figures. Excluding Red Hat, IBM is still on track for $13.90 of non-GAAP EPS and approximately $12 billion of free cash flow.
IBM asserts that starting with its first full year with Red Hat, this acquisition will be accretive to free cash flow. Having said that, Red Hat's adjusted free cash flow (accounting for stock-based compensation) was less than $800 million during its fiscal 2019. Accordingly, investors should not expect IBM's 2019 free cash flow guidance to materially change with this acquisition.
Under The Hood
IBM's Q2 2019 top-line was down 4% to $19.2 billion. IBM's CFO Jim Kavanaugh was quick to point out that this is part of IBM's strategy; going forward, IBM is deemphasizing lower-value contracts and is targeting a better margin profile for the company. As a consequence, IBM was able to boast that its gross margin expanded by 100 basis points, which was its best performance over the past five years.
Furthermore, IBM is making an effort to clean up underperforming business units held in its vast portfolio -- businesses which don't fully support IBM's vision to leverage and cross-sell its operations. This quarter IBM divested itself of two select software businesses, which brought in $575 million in cash.
Valuation - IBM is Still Too Cheap
IBM declares that Red Hat's open hybrid cloud technologies will allow for a significant amount of cross-selling into its client base. At this juncture, investors would be right to be just a little skeptical.
Also, whether the highly entrepreneurial Red Hat team will succeed in adapting to IBM's culture is another overhang facing IBM's medium-term prospects. However, despite these concerns, I contend that its stock is still meaningfully undervalued, and offers investors a large margin of safety.
These numbers speak for themselves. Investors seeking exposure to the rapidly growing cloud sector can participate in this space without having to overpay for it.
IBM is the only company with the industry expertise, customer base and long history of innovation that is trading this cheaply. Not only is IBM trading at a discount to itself, but it is still being priced at just 11x free cash flow. There are not many highly profitable, blue-chip software companies with net cash on their balance sheets trading for this sort of valuation.
The Bottom Line
While investors trip over themselves to purchase the latest high-flying cloud-based companies, some of which have no profitability on the horizon, IBM, with its long history of profits, trades cheaply.
It is certainly fair to say that IBM does not carry the sexy appeal of other fast-growing companies, but at the same time, investors holding its stock in 2019 continue to steadily grow their capital.