In 2019 IBM completed the largest acquisition of its history, buying Red Hat for $34 billion dollars. The acquisition represents just one of the many ways IBM is trying to move its business towards cloud based solutions and help its customer base become more efficient in their everyday work flow.
Large companies such as banks and airlines depend on IBM for secure and stable software systems that are used to run their business. Finance companies as an example have grown so dependent on IBM’s software that in 2019 over 90% of credit card transactions were managed through IBM’s system.
Since its founding in 1924 IBM has continued to expand into more and more areas as technology has advanced and in 2019 it categorized its mains sources of revenues into four distinct segments.
IBM’s largest segment, Global Technology Services (GTS), brings in over 35% of their total revenues and consists of the IBM cloud as well as other enterprise solutions that IBM offers to its customers to help make them more efficient.To help improve the offerings of this segment IBM has made significant efforts and investments in artificial intelligence to help their customer get more accurate data from their IBM solutions.
IBM’s second largest segment is their Cloud and & Cognitive Software, which consists of specialized software that IBM helps to develop for specific companies and industries such as financial services, internet of things, and healthcare, which helps them keep track of and manage all the data within the company in an organized and efficient manner.
Their Systems segment delivers digital storage, servers, and other hardware products that are essential in operating a cloud-based system. In addition to hardware products the Systems segment includes their z/OS and Linus operating systems, which are used for high performance and high security software applications.
IBM also has a small Global Financing segment which offers financing arrangements to its customers for hardware and software to make their offerings more affordable for their customer base.
In total IBMs segments brought in $77 billion of revenue in 2019 and operating income of $11 billion, bringing their operating margin to 13.6%. Similar to its competitors IBM spends a large portion of their total revenues on Research & Development Expenses which in 2019 made up 8% of their revenue. While 8% of revenue on R&D is large compared to many corporations it is much smaller than the 13% of revenue that Microsoft spends on their Research & Development efforts. Their high margins and use of leverage allowed IBM to end 2019 with a return on equity of 45% which is larger than both Microsoft and Amazon but still 4% shy of Oracle’s return on equity.
The key variables in determining the value for IBM consists of the following:
Sales volume of its middle-ware and data platforms
Sales of its consulting and business processes segment
Sales of its IT infrastructure and platform services such as the IBM cloud
Sales of its systems hardware such as servers and storage systems.
Out of the largest players in the cloud-based solutions industry the members of Olympus find that IBM is the company least within our circle of competence. However, for illustrative purposes we will provide a valuation based on a few assumptions, but readers should remember that the valuation stated here should serve as a starting point in establishing their own valuation, not as an ending point.
Over the past 3 years IBM has reported operating income of $13.5 billion, $13.2 billion, & 12.9 billion in 2019, 2018, and 2017 respectively. If IBM were to maintain a similar level of operating earnings with a moderate level of growth over the next 10 years and stable earnings thereafter one might very well arrive at a valuation of just under $190 billion.
This valuation however, is based on assumptions of IBM’s growth, market share, competitive position, and a number of other important factors deemed essential by Olympus Wealth Management, and further explained in Guide to Olympus Insights.
Something important to note here is that while this valuation assumes stable earnings and moderate growth, the earnings of a business such as IBM’s may very well go down over the next decade or two due to increased competition, lower margins, decrease in sales, or a great number of other factors. No investor should make the assumption that because a business’ earnings have grown in the past they will continue to grow in the future.
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Please note: Olympus Wealth Management is a Tulsa based investment fund which may or may not own holdings in IBM Inc and the reader should not take the above article as a recommendation to buy or sell IBM stock but instead as an informative article meant to increase one’s knowledge of the company.