A Dividend Aristocrat to Avoid That’s 20% Overvalued

IBM IBM remains a giant in the IT services industry for now, but the migration of business to the cloud and the availability of open-source software threaten its position. Although we assign IBM a narrow economic moat rating, we think that moat is deteriorating. Morningstar chief U.S. market strategist Dave Sekera includes this overvalued dividend aristocrat on his list of three high-dividend stocks to avoid.

IBM is the dominant provider of mainframes and a prominent player in the public cloud, data management systems, and other software products, like middleware and integration software. While the company has tried to refresh its diverse offerings, we think the cloud transition is chipping away at its competitive advantage. Historically, customers tended to entrench themselves with IBM offerings because of the ease of having a main IT services provider and the surety of IT functions having interoperability. However, with the rise of the cloud and open-source software, the possibility of mix-and-match IT infrastructure is real. We think clients will gradually reduce the IBM offerings they take as the cost of switching diminishes. But because IBM tends to serve very large customers in regulated industries, any change will be a slow one, in our view.

Key Morningstar Metrics for IBM

• Fair Value Estimate: $126
• Star Rating: 2 Stars
• Economic Moat Rating: Narrow
• Uncertainty Rating: Medium

Economic Moat Rating

We assign IBM a narrow economic moat rating based on switching costs and intangible assets. We think switching costs are prevalent because of the interconnectedness of IBM’s offerings. IBM looks to cover all aspects of a company’s IT needs: IT consulting and outsourcing, hardware, software, and cloud services. We think the advantage largely stems from IBM’s consulting business. In our view, IT services consulting firms boast high switching costs because of the continuity in understanding a client’s technology infrastructure over a long period. We believe that IBM has intangible assets in the expertise that it has acquired throughout its century-plus history, particularly in specialty areas such as the financial, airline, and networking sectors. Banks, airlines, and network providers operate in mission-critical areas and have leaned on IBM for years, allowing the company to benefit from specialty knowledge of its clients personally and the industries they operate in.

Read more about IBM’s moat rating.

Fair Value Estimate for IBM Stock

Our $126 fair value estimate implies a 2023 enterprise value/adjusted EBITDA of 12 times. We forecast revenue will rise at a compound annual growth rate of 3% over the next five years as the company benefits from digital transformation work. Driving our financial model is our expectation for IBM to benefit from growing software and consulting sales, though at a more moderate pace than its peers in both industries. We forecast IBM’s hardware business to continue to be lumpy. We do not think direct Red Hat sales will play a large part in organic revenue growth. We expect IBM’s gross margin to gradually increase from 54% in 2022 to 55% in 2027 as the company improves its mix of business.

Read more about IBM’s fair value estimate.

Risk and Uncertainty

We see the risk of competition from cloud providers moderated by IBM’s low customer concentration and large but slow-to-change customer base. We think the company’s outsourcing business is the most at risk as many customers increasingly become aware of outsourcing capabilities that their cloud services providers can take over, with higher-quality servicing or more technologically advanced capabilities. We are also unsure about the company’s ability to monetize much of its ongoing development. While IBM is creating quantum computers, they are not yet ready for commercial use. Once they are, the market for enterprises that can afford these machines will be minute, in our opinion.

Read more about IBM’s risk and uncertainty.

IBM Bulls Say

• IBM’s customers could be even stickier than expected, emphasizing the mission criticality of mainframes and databases and choosing not to rock the boat even on ancillary applications.
• If the Watson platform undergoes a turnaround and proves its efficacy, it could boost IBM’s software sales and potentially cloud services.
• IBM should gain traction in its shipping blockchain-based solutions as its network of logistics partners becomes harder and harder to replicate.

IBM Bears Say

• Even the stickiest customers might find it worthwhile to switch to IBM’s competitors in software and cloud offerings and, in turn, minimize the size of the company’s IT services accounts.
• If cloud reliability increases drastically, it could significantly cut the costs of switching from IBM mainframes to the cloud.
• IBM’s Db2 database could see significant churn as other databases’ applications increasingly outweigh the costs of switching systems.

This article was compiled by Susan Dziubinski and Sylvia Hauser.