Summary
- The rapidly growing cloud market is predicted to stay above 14% annual growth in the coming years.
- IBM's strategic acquisition of Red Hat create excellent synergies in a high-growth cloud market.
- Our DCF Analysis is based on in-house revenue forecasts, generating a fair value of $176.59.
Opportunity Summary
With Red Hat now under IBM’s (NYSE: IBM) empire, we believe IBM’s large investments in the hybrid cloud and AI-driven data services are highly synergistic growth accelerators.
IBM’s sluggish growth could finally turn around by 2021, when its acquisition of the Linux cloud enterprise leader Red Hat is fully reflected in its performance. IBM Red Hat is creating the first fully hybrid multi-cloud environment (private cloud + public cloud + on-premise platforms). The deal is also about the data. Largely overlooked by the market is the value potential of the enterprise data that Red Hat brings, combined with IBM’s AI data capabilities, to attract more enterprise workload to IBM Red Hat hybrid cloud solutions.
This major acquisition by IBM should be seen in the light of a rapidly growing $1.2 trillion hybrid cloud market. Hence, patient value investors who start accumulating shares now at $145 could benefit from a discount, which we value at 69 percent, before Red Hat starts adding to the top line in 2021.
Slowing sales of its strategic cloud growth initiative – down 3 percent in Q2 2019 on a YoY basis, compared to 15 percent growth in the first half of 2018 – provide a buying opportunity.
A rapidly growing cloud market
As its legacy businesses continue to contract, IBM is looking to its cloud business to lead the company on a new growth trajectory. Red Hat is growing revenues at a much faster rate than IBM (3-year revenue growth of (20% vs 1.5%), and operates at higher gross margins (85% vs 47%).
Furthermore, the acquisition of Red Hat generates clear synergies, which will help boost revenues. Red Hat is the leader in enterprise hybrid cloud solutions while IBM has the lead in enterprise big data and analytics. Eighty-four percent of enterprises have a multi-cloud strategy, and the majority are migrating to a hybrid cloud strategy. IBM plans to provide those hybrid customers with AI-driven data, models, and tools to manage data anywhere. IBM’s Watson AI can now be deployed on any public or private cloud, including those of leading competitors AWS (NASDAQ:AMZN), Microsoft Azure (NASDAQ:MSFT), and Google (NASDAQ:GOOGL).
The overlooked data play will be the catalyst for taking IBM stock out of its depressed slump. After trailing the S&P 500’s return of 6.8 percent by 1 percent over the past 15 years, IBM stock is up 30 percent year-to-date. Based on analyst estimates, the stock price of 145 appears to be fairly valued, but those estimates are undervaluing AI-driven data as an accelerator of IBM Red Hat cloud adoption, and demand for related hybrid cloud migration and AI consulting services.
