IBM's (IBM) - Get International Business Machines (IBM) Report share price has picked up nicely of late, with its stock up about 24% year-to-date, meaningfully outperforming the S&P500 (SPY) - Get SPDR S&P 500 ETF Trust Report . Many IBM shareholders are attracted to IBM's large dividend yield of nearly 4.5%, which is nice to have but doesn't highlight the full story. I argue that IBM is meaningfully undervalued and offers investors a large margin of safety.

Recent Financial Performance

IBM's last quarter of the year was not as strong as many had hoped for. Q4 2018 revenue was down 1% to $21.4 billion (at constant currency), while its non-GAAP EPS was $4.87 (down 5% year-over-year). Having said that, if we step back and appraise IBM's full-year 2018 performance, its revenue was actually flat year-over-year at $76.1 billion, while its non-GAAP EPS was better and ended up 1% to $13.81.

In other words, IBM had one poor quarter to end the year. But the full year's financial performance was strong, leading to strong free cash flow of $11.9 billion.

Looking ahead, IBM's free cash flow for full-year 2019 is expected to be flat and once again come in at roughly $12 billion. This implies that IBM's market cap trades for just under 11x free cash flow, which for a well-diversified, share repurchasing conglomerate appears to be unreasonably cheap.

Strategic Imperatives - Crown Jewel Or Not So Much?

Compounding issues for IBM are the fact that IBM's Strategic Imperatives are not growing as fast as desired. As a reminder, IBM's Strategic Imperatives was meant to be its most promising opportunities, which IBM separates and highlights to investors as its fastest-growing business units.

At the end of Q4 2018, IBM's Strategic Imperatives accounted for close to 50% of IBM's revenue. Furthermore, this promising basket of businesses finished Q4 2018 with just 5% growth, and 9% growth for 2018. Consequently, many investors and analysts are now questioning whether these signposted businesses will gradually be highlighted less and less.

But this is what I strongly believe is investors' main opportunity. Current sentiment towards IBM is particularly negative. There is minimal hope that IBM will succeed in reinventing itself and repositioning itself as a fast-growing business once again.

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On the other hand, I argue that IBM's acquisition of Red Hat, the hybrid cloud market leader it bought for $34 billion, is just what IBM needs to remain relevant in the cloud wars. Red Hat's technology, together with IBM's infrastructure and consulting sales force will allow IBM to hold on to crucial market share in the fast expanding cloud sector.

Consequently, if IBM indeed holds on to its market share, and is recognized for holding its weight against the likes of Amazon's (AMZN) - Get, Inc. Report AWS, Microsoft's (MSFT) - Get Microsoft Corporation (MSFT) Report Azure and Alphabet's (GOOGL) - Get Alphabet Inc. Class A Report Google Cloud, investors will be sure to reward IBM with a higher multiple over time.

Valuation - Large Margin Of Safety

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IBM is largely exposed to the same industry dynamics as Amazon's AWS or Microsoft Azure and should be rewarded somewhat similarly, although IBM's execution has admittedly not been particularly strong of late. However, IBM's valuation is already more than factoring this in already. 

I argue that IBM's share price is so low at present that any surprises from here on out are more likely to be on the upside rather than on the downside, as investors are so very much despondent when it comes to IBM.

The Bottom Line

To buy when others won't is extremely challenging. But this is a strategy which ultimately generates the strongest returns. IBM's performance this past five years has been truly lackluster. Nevertheless, I argue that its current share price already accounts for this negativity many times over.

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I have no positions in any stocks mentioned.