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What Kind of Company Will IBM Be in Three Years?

Over the last three years, the stock of IBM (NYSE:IBM) has lost approximately 5% of its value, whereas the S&P 500 has gained approximately 50%. As the aging technology behemoth struggled to generate consistent revenue growth, many investors shied away from investing in it entirely.

As a result of this continued decline in IBM's business software, hardware, and information technology services divisions, which has outpaced the growth of the company's newer cloud-based divisions, investors have lost patience with the company's slow-moving turnaround efforts.

With the acquisition of Red Hat for $34 billion in 2019, IBM attempted to bolster those efforts even further. While Red Hat's revenue increased by 18 percent in 2020, IBM's total revenue decreased by 5 percent as the company struggled to cope with pandemic-related disruptions during the same period of time.

Announcing the appointment of Arvind Krishna as the company's new CEO in April, IBM stated that the company's focus would be on expanding the company's presence in the hybrid cloud and artificial intelligence (AI) markets. Six months later, IBM announced the separation of its Global Technology Services division's managed infrastructure services unit from the remainder of the division.

The "new" IBM will continue to grow its hybrid cloud and artificial intelligence businesses after the spin-off is completed later this year, while Kyndryl will take over one of the company's slowest-growing segments.

IBM recently held an investor briefing to clarify its spin-off plans and outline its financial objectives, despite the fact that many investors were unimpressed by the plan. In this section, we'll look at the most important takeaways from the presentation and how they might affect IBM's stock price over the next three years.

It is estimated that IBM will generate "sustainable mid-single-digit revenue growth" between 2022 and 2024, or approximately $3 billion in new revenue per year during this time period. They believe the growth in their hybrid cloud, consulting and security businesses will more than offset the slower growth in their remaining infrastructure-focused businesses.

Following the separation of Kyndryl from IBM, the company expects to see an increase in revenue from its higher-growth software and consulting divisions. Following the spin-off, these higher-growth segments will account for approximately 70 percent of total revenue in 2020, up from 55 percent in 2020. Following the spin-off, IBM's retained software businesses will generate 45 percent of the company's recurring revenue in 2020, with that percentage increasing to 65 percent after the spin-off.

A simpler business model

Following the spin-off, IBM's reporting segments will be reduced from five to four: consulting (which will account for 29 percent of revenue from continuing operations in 2020), software (which will account for 42 percent), infrastructure (which will account for 25 percent), and financing (2 percent ).

The consulting business will provide services in the areas of business transformation, technology consulting, and application operations management. It is expected that the segment will grow at a high single-digit rate between 2022 and 2024, with a pre-tax profit margin in the low teens.

Red Hat's hybrid cloud, artificial intelligence, security, and transaction processing divisions will be combined with IBM's software business to form a new software business. It expects Red Hat's sales to grow in the high teens this year, and the software segment as a whole to grow in the mid-single digits, with a pre-tax profit margin of nearly 30%.

IBM's infrastructure business will include hardware and software for infrastructure, as well as public cloud and edge computing services, as well as other related technologies. With revenue growth expected to be roughly flat in the medium term, IBM expects a pre-tax profit margin in the mid-teens for this segment in the long term.

According to IBM, its free cash flow (FCF) will increase by the high single digits each year between 2022 and 2024 as a result of these enhancements. It is estimated that the company will generate approximately $750 million in annual free cash flow growth and a cumulative free cash flow of $35 billion over the next three years. IBM intends to distribute a portion of the cash to shareholders and use the remaining funds to make new investments, according to the company.

The company's shareholders should expect it to spend a larger portion of its cash on investments and acquisitions, particularly to strengthen its software and consulting businesses, rather than on stock buybacks or dividend increases. Initially, IBM and Kyndryl will pay a combined dividend equal to IBM's current dividend, but the payouts of both companies may be reduced as a result of their separation from one another.

Where will IBM's stock be in three years?

Despite the fact that IBM's plans appear to be promising, the company faces fierce competition in the software and consulting industries. Cloud computing giants Amazon (NASDAQ:AMZN) and Microsoft (NASDAQ:MSFT) are leveraging "virtual private clouds" to expand their public cloud platforms into the hybrid cloud market, while fast-growing IT companies such as Accenture (NYSE:ACN) and Globant (NYSE:GLOB) are squeezing the consulting market.

If, on the other hand, IBM achieves its growth objectives, its stock price may begin to recover. Currently trading at 12 times forward earnings, the stock appears to be extremely undervalued, and it may become even more attractive after it separates from Kyndryl. Investors who own IBM stock should hold on to their holdings and wait to see if the company's three-year turnaround plans are successful. However, if you do not already own the stock, you should hold off on reevaluating the "new" IBM until the spin-off is completed.

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