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Don't Be Fooled by IBM's Surprising Revenue Growth

This week, International Business Machines (NYSE: IBM) posted surprising year-over-year revenue growth during the first quarter. Investors shouldn't get too excited, though. Big Blue's top-line performance wasn't that impressive, and management didn't upgrade its full-year outlook. Yet thanks to its modest valuation in the context of its transition to the cloud, IBM remains an attractive investment opportunity.

Contrasted top-line performance

IBM's first-quarter revenue grew by 1% year over year to $17.7 billion -- the highest revenue growth for the company since the second quarter of 2018. Granted, that result pales in comparison to the spectacular performance of some tech specialists over the last several quarters. But it represents an encouraging improvement compared to the 1.5% year-over-year decline in revenue to $17.3 billion analysts had anticipated.

Image source: Getty Images.

However, investors shouldn't get too excited about this positive outcome, for a few reasons.

First, thanks to its international footprint, IBM benefited from favorable currency exchange rates. At constant currency, revenue declined 2% year over year.

Second, during the earnings call, CFO Jim Kavanaugh indicated the unexpected strong results of the mainframe business, up 49% year over year at constant currency, corresponded to a couple of hundred million dollars of extra revenue. Indeed, the boost in demand for IBM's mainframe z15 represents a positive development, but it's not a sustainable source of revenue growth given the cyclical nature of that business.

Lastly, despite the surprising top-line performance, management didn't update its full-year outlook, which suggests first-quarter better-than-expected revenue growth wasn't an early sign of long-term improvement in the company's prospects. Consistent with the previous quarter, management anticipates full-year revenue to grow year over year (without giving further details) and adjusted free cash flow to land in the range of $11 billion to $12 billion.

Vast cloud opportunities

Leaving aside the company's quarterly top-line performance, IBM remains a bet on its transition to cloud computing and artificial intelligence (AI). Since its $34 billion acquisition of Red Hat in 2019, IBM's cloud activities have been generating strong double-digit growth that contrasts with the decline of the company's legacy businesses.

During the first quarter, revenue from cloud activities grew 21% year over year to $6.5 billion, which confirms the success of the company's focus on solutions that allow applications to run on any combination of private and public cloud (hybrid cloud) thanks to its flagship product OpenShift.

Granted, IBM will be facing strong and increasing competition in the hybrid cloud area, as illustrated by Microsoft's recent efforts to offer management solutions for hybrid clouds with its Azure Arc offering. But the huge size of that market leaves plenty of room for Big Blue -- and its competitors -- to keep generating strong double-digit revenue growth over the next several years.

And to capture a part of that large opportunity management had estimated at $1 trillion, IBM has been creating partnerships that leverage its hybrid cloud solutions and consultancy activities. For instance, it partnered during the last quarter with the big data specialist Palantir Technologies to facilitate the deployment of Palantir's data analysis capabilities on hybrid clouds.

An attractive bet

So despite IBM's not-that-strong first-quarter performance, investing in the company still offers attractive exposure to cloud computing and AI.

Indeed, IBM's market cap represents only 10.7 times the mid-range of management's forecasted full-year adjusted free cash flow. You should take this year's adjusted free cash flow with a grain of salt, though. The company will record cash charges of $3 billion (excluded from adjusted free cash flow) to fund its transformation, which includes the separation of its legacy managed infrastructure business it announced in October.

But beyond the short term, executives expect cloud and AI initiatives to keep supporting revenue growth. And adjusted free cash flow should increase to a range of $12 billion to $13 billion in 2022.

Thus, even if IBM's surprising first-quarter revenue growth didn't get me more excited, I'm still happy to hold my shares given the company's low valuation in the context of modest long-term revenue and free cash flow growth.

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Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool's board of directors. Herve Blandin owns shares of IBM. The Motley Fool owns shares of and recommends Microsoft and Palantir Technologies Inc. The Motley Fool has a disclosure policy.


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