Revising IBM To $204

International Business Machines (NASDAQ:IBM) was one of the worst performing stock in 2014. While the NASDAQ stock index was up by more than 10% in 2014, IBM’s stock declined by 17% during the year. The primary reason for this was the decline in revenues across all of its reporting segments. The fall in revenues was further accentuated by the sale or pending sale of some of the underperforming assets such as x86 server division and microelectronics fabrication units, which cumulatively accounted for nearly $4 billion in revenues. In addition to these divestments, the company had sold its customer care business process outsourcing unit in 2013, which resulted in a decline in revenues and outsourcing backlog in 2014. Based on these events, we have recently revised IBM’s stock price to $204. Despite this revision, out stock price is 30% higher than the current market price. In this note, we explore the reason for our price revision and discuss key factors that contribute to our belief in IBM’s long-term potential.

See our full analysis on IBM

IBM Leads The Middleware & Software Market

The Software division is the biggest contributor to IBM’s stock value and makes up nearly 63.5% 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% 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. ^[1] 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.

In operating system domain, due to lower sales of its power system servers as a result of it being in later phase of the product cycle, sales have failed to deliver growth. However, as the company refreshes its product line we expect revenues to stabilize that should help the company to shore up growth.

Revenues From Cloud Services To Bolster GTS And GBS Businesses

IBM’s services division contributes 23% to IBM’s estimated value. In the past few quarters, the services backlog, which indicates the contract value the signings yet to be delivered as revenue, has declined from $143 billion in 2013 to $128 billion at the end of Q3 FY14. It has declined due to host of reason ranging from hiving off customer care business to tepid business environment that has resulted in fewer contract signings during the year. Furthermore, IBM has been consciously not signing contracts that offer low margins. However, it is focusing on building its cloud business and offering more of its services through cloud. IBM’s 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 2014 that include Cloudant Inc, Sliverpop System, CrossIdeas and Lighthouse security group etc.

Cloud services, on both public and private clouds, are expected to reach a market size of $555 billion in 2020 from $209.9 billion in 2014 at a CAGR of 17.6%, according to the new report by Allied Market Research. ^[2].  According to  Infonetics Research, the public cloud market is poised to grow to over $200 billion by 2018. ^[3] Within the public cloud services, IaaS is expected to grow from about $23 billion in 2014 to $34 billion in 2015, and PaaS to grow from 13% of the total cloud revenue in 2013 to 16% in 2018. ^[4] According to Forrester, SaaS solutions accounted for $36 billion in revenue in 2013, and are expected to increase to $133 billion by 2020. ((The Public Cloud Market Is Now In Hypergrowth, April 24 2014, www.forrester))

IBM’s technology services (GTS) and global business services (GBS) divisions together make revenues of nearly $57 billion. 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 $36 billion and GBS revenues will grow to $18 billion by the end of 2021.

System And Technology Division To Turn Around

IBM’s system and technology division, which maps onto our server, storage and other division, has been bleeding cash as it was operating in the unprofitable commoditized x86 server market and Microelectronics division that failed to gain traction with original equipment manufacturers. This division has lost close to $1 billion in first nine months of 2014. 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. In 2014, IBM sold off its server division to Lenovo and agreed to pay Globalfoundries $1.5 billion to take over the chip-manufacturing division. We believe that this should help the company to report bottom-line growth.

Furthermore, the company has embarked upon a “workforce rebalancing” or job cuts to improve its profitability. Most of the company’s cost cutting measures are centered on the ailing system and technology business. We believe that 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 2.52% in 2014 (estimated) to 18% by 2021 due to these efforts.

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More Trefis Research

1. Report: IBM Named Market Share Leader in Application Infrastructure and Middleware Software for 13 Consecutive Years, April 1 2014, www.ibm.com [↩]
2. Global Cloud Services Market is Expected to Reach $555 Billion by 2020, July 2 2014, www.bizcloudnetwork.com [↩]
3. Cloud services to top $200 billion by 2018; Google, IBM, Amazon lead market, November 13 2014 [↩]
4. Worldwide Competitive Public Cloud Platform as a Service 2014–2018 Forecast and 2013 Vendor Shares, July 2014 [↩]