IBM Looks Toward Cloud Solutions for Growth

Narrow-moat IBM's IBM third-quarter revenue of $18 billion missed consensus estimates as sales declined 3.9% year over year. The cloud and cognitive software segment, which now includes Red Hat, increased sales by 6.4% year over year, with bright spots in security, Internet of Things, and hybrid cloud offerings. Compared with the prior year, global business services expanded by 1% due to consulting strength; however, global technology services, systems, and global financing declined by 5.6%, 14.7%, and 11.7%, respectively. Although IBM is still transitioning its overall business, we believe Red Hat gives the company a favorable boost to its longer-term offerings for hybrid-cloud ecosystems, and we are maintaining our $158 fair value estimate. We view shares as slightly undervalued after falling about 5% afterhours, but acknowledge the uphill battle the company is facing in transforming its business and would wait for a better risk for reward entry point.

IBM reiterated full-year expectations, initially stated in August, of GAAP EPS being at least $10.58, non-GAAP EPS minimum of $12.80, and free cash flow of about $12 billion. We believe IBM is wisely focusing on evolving its business to capitalize on enterprises shifting workloads to cloud-based resources. With Red Hat's Linux expertise and its OpenShift container application platform, IBM has more opportunities to stay ahead of how developers and infrastructure teams are consuming resources in hybrid-cloud networks. In our view, IBM has acknowledged the shift in customer buying behavior from large upfront hardware purchases and toward more consumption-based solutions and services that can offer tools like analytics, monitoring, and computing on-demand. While IBM still has a long way to go to challenge the large hyperscale cloud providers, we believe the company is headed in the right direction to remain a force in the IT environment.

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