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IBM Is The Perfect Example Of Why Size Matters: An Earnings Story

International Business Machines stock price

International Business Machines (NYSE: IBM) share rose by as much as 3.0% to mark the high for Thursday's trading session. The reaction came from the company's second quarter 2023 earnings results, which were released during the post-market hours of Wednesday evening. Considering what markets value in today's environment, IBM has found part of the support it needs to attract more investors into the stock.

As the United States economy begins to pivot, as a direct result of FED interest rate hikes and withdrawal of liquidity from the economy, investors are beginning to value reliable cash flows rather than obscene growth prospects. This can be seen by the direct reaction in IBM's stock, despite reporting low to mid-single-digit growth rates, followed by similar expectations for the future.

Investors can rely on a cyclical capital rotation into size and yield, which can only be achieved by reliable free cash flows in a business, all of which IBM provides. These benefits have yet to be priced into the market and analyst targets.

Not too Shabby of a Quarter

Revenue for the quarter reported a 0.4% decline over the past twelve months, mainly driven by infrastructure segments contracting. Considering that every other segment in the company posted reasonable growth, markets were able to shrug off these contractions quickly. 

As all the growing segments naturally carry higher margins, it was easy for IBM to report a total 1.8% expansion in operating margins, leading directly to increased operating cash flows. These cash flows grew to $6.4 billion for the quarter, up $1.8 billion from a year prior. Free cash flow, the lifeblood investors should always demand from IBM, increased to $3.4 billion for the quarter.

Because the infrastructure segment is the only one expected to keep slowing for the rest of the year, management could confidently point investors toward reasonable full-year 2023 expectations. Firstly, free cash flow is expected to be approximately $10.5 billion, representing an annual advance of over $1 billion. 

This matters for investors who are fending to purchase some of IBM's shares. Because markets are now deemed 'riskier' as seen by the rising yields in the U.S. treasury bonds, some stocks which previously promised fantastic growth profiles are now being washed out with the market's changing tides.

IBM's market capitalization (stock price multiplied by the number of shares) will be over $125 billion as of today's prices, making it a 'large cap' stock. This group of large companies is expected to grow less organically because IBM is so big, and its free cash flows are so vast; the company can begin to spark growth by acquisitions and share buybacks.

Why Money likes IBM

Within the company's quarterly earnings presentation, IBM's CFO, James Kavanaugh, points to the firm's strong cash position and strong free cash flow generation as a source of growth. Explicitly mentioning the company's seven acquisitions to be made to ".... bolster our hybrid cloud and AI strategy while continuing to return value to shareholders through dividends."

The key here is potential growth via these acquisitions and an attractive (and safe) yield resulting from increasing dividends. IBM's dividend yield is a rather attractive 4.8%, one of the highest yields in firm history. As markets begin to rotate into safer yields and more reliable free cash flow generation models, IBM finds itself in a sweet spot for both high yield and high appreciation potential.

IBM analyst ratings agree on a negligible 2.4% upside potential from today's prices, which may reflect the earnings expectations. Analysts are pointing to 4% to 6% growth for the coming year with regard to EPS, which may be a boring statistic for markets, though not for shareholders. 

Considering that, during the past twelve months alone, IBM grew their EPS by nearly 13% due to previous acquisitions and industry dynamics accruing to margin expansion; investors could expect a repeating chapter for next year. With seven new acquisitions and the intention to increase dividends, analysts will likely need to raise their outlooks and price targets as well.

The only competitors close to IBM's size bracket, names like Accenture (NYSE: ACN) and Fiserv (NYSE: FI), can give investors the final pillar they need to consider a potential buy in IBM stock. Forward price-to-earnings ratios, which value the subsequent twelve-month earnings rather than the past twelve, all suggest that IBM is the underrated value play in this small group.

IBM trades at a 13.8x forward P/E, while Accenture and Fiserv trade at a more expensive 25.0x and 15.4x, respectively. So here they have it, attractive dividend yield, strong cash flows fueling growth via acquisition, and a discounted valuation to the peer group. The only catalyst investors need is an analyst price target upgrade based on the latest results and the above dynamics.

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