IBM Stock’s Prospects Aren’t So Bright

International Business Machines (IBM) is one of the world’s leading cloud and data analytics providers. I am neutral on the stock.

Lower IT Spending

According to UBS analyst David Vogt, IBM will recognize lower IT revenue moving forward after its Kyndryl spin-off.

Vogt claims that the Kyndryl spin-off leaves the stock overvalued and was quoted saying the following for his 9.7% price downgrade: “While some expansion was to be expected post the spin from the ~10x long-term average given an ‘optically’ better PF revenue outlook and margin profile, if [multiples] mean revert to ~10x, shares could fall 15-20%, below our base case.”

Vogt’s statements may be controversial because IBMs spin-off of Kyndryl may be seen as a streamlining process by many as the company’s currently on a mission to tie up loose ends on capital allocation. I, for one, see his claims on top-line growth as well-founded because investors tend to overemphasize revenue growth instead of looking at the complete income statement.

Valuation

The market is set up for a cyclical swing amid rising interest rates. The lower interest rate environment we lived through in 2020/21 allowed technology firms to substantiate significant gains as their cash flows were realized much earlier than anticipated pre-pandemic.

We’re, however, set for a mean reversion, and IBM could be on the bad end of the stick. IBM’s stock is overvalued by 36.8% if measured on price/earnings relative to its five-year average and 20.5% if measured by its forward PEG ratio, suggesting that earnings are no longer keeping up with the stock’s growth.

Another concerning aspect of IBM is its ROE growth. The company’s ROE growth is estimated at 13.6% for the next year, while its cost of debt may become elevated amid a rising yield environment. This will likely add up to a decreasing intrinsic value, subsequently encouraging investors to sell the stock.

Dividends

IBM’s dividend payout capacity is absent. The stock’s key ratios paint a negative picture, with IBM’s payout ratio at 119%, suggesting that its currently extending itself with shareholder compensation.

In addition to the relevant payouts measurement, IBM’s dividend coverage and interest coverage ratios are 23.5% and 43.3% below their five-year averages, respectively. These data points convey that IBM will likely have to pay off a significant amount of debt before it can continue rewarding its shareholders.

Wall Street’s Take

Turning to Wall Street, IBM has a Strong Buy consensus rating, based on five Buys, four Holds, and one Sell assigned in the past year. The average International Business Machines price target of $153.79 implies 14.8% upside potential.

Concluding Thoughts

IBM stock has run its course for now. Rising rates will likely damage the stock’s future cash flows, which could cause a reversion to the stock’s fair value.

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