Shares of International Business Machines (NYSE:IBM) rose 3.0% to mark the top of Thursday’s trading session. The reaction came from the company’s second-quarter 2023 earnings results, which were released during post-market hours on Wednesday evening. Given what the markets are enjoying in the current environment, IBM has found some of the support it needs to lure more investors into the stock.
As the US economy begins to pivot, as a direct result of the FED’s interest rate hikes and the withdrawal of liquidity from the economy, investors are beginning to value reliable cash flow over obscene growth prospects. This can be seen by the direct reaction of IBM’s shares, despite low to mid-single digit growth rates, followed by similar expectations for the future.
Investors can count on a cyclical rotation of capital in size and return, which can only be achieved by reliable free cash flow in a business, all of which IBM provides. These benefits have yet to be incorporated into market and analyst goals.
Not too shabby a quarter
Revenue for the quarter was down 0.4% over the last twelve months, mainly due to the contraction of the infrastructure segments. Considering that all other segments of the company showed reasonable growth, the markets were able to quickly ignore these contractions.
As all growing segments naturally generate higher margins, it was easy for IBM to announce a 1.8% total increase in operating margins, directly leading to increased operating cash flow. These cash flows reached $6.4 billion for the quarter, up $1.8 billion from a year earlier. Free cash flow, the lifeblood investors should always demand from IBM, increased to $3.4 billion for the quarter.
Given that the infrastructure segment is the only one that is expected to continue to slow for the remainder of the year, management could confidently steer investors toward reasonable expectations for 2023. First, free cash flow is expected to be around $10.5 billion, representing an annual advance of over $1 billion.
This is important for investors who are scrambling to buy some of IBM’s stock. As markets are now deemed “riskier,” as evidenced by rising US Treasury yields, some stocks that once promised fantastic growth profiles are now being swept away by market swings.
IBM’s market cap (stock price multiplied by number of shares) will be over $125 billion at today’s prices, making it a “large cap” stock. This group of large companies is expected to grow less organically because IBM is so big and its free cash flow is so vast; the company can begin to drive growth through acquisitions and share buybacks.
Why Money loves IBM
In the company’s quarterly earnings presentation, IBM Chief Financial Officer James Kavanaugh points to the company’s strong cash position and strong free cash flow generation as a source of growth. Explicitly mentioning the company’s seven acquisitions to be made to “…enhance our hybrid cloud and AI strategy while continuing to return shareholder value through dividends.”
The key here is potential growth via these acquisitions and an attractive (and secure) return from increased dividends. IBM’s dividend yield is quite an attractive 4.8%, one of the highest yields in the company’s history. As markets begin to turn toward safer returns and more reliable free cash flow generation models, IBM is in an ideal position for high yield and high upside potential.
IBM’s analyst ratings agree on negligible upside of 2.4% from today’s prices, which may reflect earnings expectations. Analysts are pointing to 4% to 6% growth for the year ahead in EPS, which may be a boring statistic for markets, but not for shareholders.
Considering that in the last twelve months alone, IBM has increased its EPS by nearly 13% due to prior acquisitions and industry dynamics driving margin expansion; investors could expect a repeating chapter for next year. With seven new acquisitions and plans to increase dividends, analysts will likely also need to raise their outlook and price targets.
The only competitors close to IBM’s size bracket, names like Accenture (NYSE:ACN) and Fiserv (NYSE:FI), can give investors the last leg they need to consider a potential purchase of IBM stock. Forward price-to-earnings ratios, which value earnings for the next twelve months rather than the last twelve, all suggest that IBM is the underappreciated value game in this small group.
IBM is trading at a forward P/E of 13.8x, while Accenture and Fiserv are trading at a higher price of 25.0x and 15.4x, respectively. So they’ve got it here, an attractive dividend yield, strong cash flow fueling growth via acquisition, and a discounted valuation relative to the peer group. The only catalyst investors need is an upgrade to analysts’ price target based on the latest results and momentum above.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.