While IBM's (IBM) Q4 2018 results delivered a mixed bag of performance, its valuation is clear cut. IBM is a bargain opportunity for patient and contrarian investors.
Q4 2018 Results - The Market Starts To Take Note
IBM released its Q4 2018 results last month and its share immediately soared after hours by more than 5%. Shares have continued to climb slowly over the past four weeks. As a reminder, IBM's Q4 2018 top-line was down 1% at constant currency to $21.4 billion and on the bottom line, non-GAAP EPS was down 5% year-over-year to $4.87.
IBM's strategic imperatives is a basket of businesses that IBM believes offer IBM significant growth potential. Yet they were only up 5% to $40 billion for the year. Presently, IBM's strategic imperatives account for half of IBM's total revenue.
Show Me the Money
If investing is fundamentally about a business's ability to be free cash flow generative, rather us being speculators trading sardines (a nod to Seth Klarman's Margin Of Safety), then IBM passes with flying colors. IBM's free cash flow guidance for 2019 comes in at roughly $12 billion, which is flat with 2018 and offers investors no real concerns.
Furthermore, we should be mindful that IBM's management showed much confidence in the company. IBM deployed a large amount of capital during a very volatile and scary time -- the Q4 2018 market sell-off when IBM's shares traded at a 10-year low.
Specifically, during this period IBM repurchased $2 billion worth of shares or close to half of the $4.4 billion IBM returned during 2018. Furthermore, to put IBM's 2018 share repurchases into context, this figure was higher than both 2017 and 2016.
IBM's Management Team
This is a massively contentious topic. Many investors will rightly say that IBM's C-suite is overpaid for delivering lackluster performance. For example, CEO Ginni Rometty's take home package often reaches north of $15 million for the year, with 2016 being a particularly outstanding year for her, as she received over $32 million.
Critics argue that this management is not aligned with IBM's shareholders, who saw their shares fall by more than 30% over the past nine years.
In my opinion, though, this type of insight does play any significant role in the opportunity at hand today. Today, as IBM trades at $125 billion market cap, this type of thinking is more of a distraction that anything else. Moreover, I passionately assert that this line of thinking is already more than priced in.
Valuation - Apathy Won't Last Forever
As the table above shows, investors are thoroughly disenchanted with IBM. IBM's cash flows from operations are valued at a multiple in the single digits, showing that investor sentiment towards IBM could not be more pessimistic.
Additionally, we can see that the other cloud operators are very much in favor with investors and trade for double (or more) the multiple to cash flow from operations of IBM.
Investors appears to believe that the cloud wars are a winner take all battle, but that could not be further from the truth. Many wrongly believe that Amazon (AMZN) will continue to hold its dominance over this sector as it did with retail. However, the truth of the matter is it's likely to be quite the opposite, with numerous smaller players offering very niche services, and larger players focusing instead on privacy over price.
I argue that this space is only going to become more and more fragmented and that IBM's runway following its acquisition of Red Hat, the hybrid cloud market leader, offers the company a huge and under-appreciated medium-term potential.
As a value investor, the name of the game is not to lose capital. And with patience in your arsenal, when buying a cash flow-generating asset that is also meaningfully undervalued, more can go right than go wrong.
Therefore, while IBM certainly has many aspects that are not being operated satisfactorily, I assert that patient investors will be rewarded over time by being invested at this price point.