An American AI play at a fair price

Hype is all well and good, but for these valuations to stay elevated AI will have to be adopted by the wider corporate world – and corporations will need help. IT giant IBM (US:IBM), with its big consulting arm, could be key to facilitating the transition. 

A company that wants to integrate AI into its operations has a lot to consider. It might choose to use an off-the-shelf generative AI product such as Microsoft’s new 365 Copilot. However, if it wants a customised product trained on its own data, that is a lot more work. The company would need to choose a foundational large language model and then organise its own data in an accessible way in order to train it.

All this work requires digital transformation consultants such as IBM and Accenture (US:ACN). The difference between the two is that Accenture started out as a consulting business while IBM has morphed into one over the past two decades and still has a legacy low-margin mainframe business. Correspondingly, Accenture trades at more that double IBM's price to cash flow valuation. In recent months, however, IBM’s consulting business has been taking market share from Accenture, and the valuation discrepancy has been called into question.

A tale of transformation 

IBM – or International Business Machines, to use its full title – used to be a hardware company specialising in mainframe computers. These were powerful computers that organisations used for large-scale data processing, and were crucial to IBM's success. In the early 1990s, it was consistently one of the five largest companies in the world by market capitalisation.  

However, the development of the microchip and the internet led to the decentralisation of computing and the rise of the PC. Although IBM was an early mover in the PC market, it was soon outmanoeuvred by lower-cost producers such as Dell and HP, and eventually sold its PC division to Lenovo in 2005. 

This sale completed IBM’s shift away from PC hardware. In 2002, it acquired PWC’s consulting business and more recently in 2019 it bought open-source software business Red Hat. Last year, it made 43 per cent of its revenue from software, 32 per cent from consulting services and 23 per cent from infrastructure. It now has more than 20,000 AI and data consultants.

Software and consulting were IBM's fastest growing business lines last year, with revenue rising 5.8 per cent and 4.5 per cent respectively, according to estimates by Melius Research. Analyst Ben Reitzes at Melius expects consulting revenue growth to keep accelerating over the coming years as “companies will increasingly need help from IBM’s consultants in picking large language models, prepping data, creating apps and monitoring performance”.

IBM’s consulting bookings have certainly picked up rapidly, with year-on-year growth in the second and third quarters of 22 per cent and 28 per cent, respectively. This was an acceleration from just 7 per cent in the first quarter. Accenture’s bookings were flat in the same period. 

The market doesn’t expect consulting bookings growth to stay above 20 per cent, but there is hope it could keep hitting double digits. Meanwhile, consultant revenue growth is expected to pick up to 6.8 per cent next year, according to consensus estimates. 

Reitzes believes IBM’s software business gives it an advantage over Accenture, as it creates an abundance of cross-selling opportunities. In July, for example, IBM began selling its Watsonx platforms to clients. Watsonx.ai studio is a platform that provides new foundational large language models, on top of which clients can build their own chatbots. There is also Watsonx.data, which helps companies unify and utilise their proprietary data.

Other types of software are also proving a hit. Red Hat is an open-source software business known for Red Hat Enterprise Linux, an operating system designed specifically for enterprise customers. There is also Red Hat OpenShift, a program that allows developers to deploy and manage applications in the cloud. In 2022, Red Hat increased its sales by 17 per cent at constant currency.

It was given an important boost by OpenShift AI, which can monitor and manage the life cycle of AI applications and had $1bn in annual recurring at the end of 2022.

The one disappointing aspect of the company is the infrastructure division. This is effectively IBM’s legacy mainframe business and revenue fell 6 per cent in 2023, according to analyst estimates (the group has yet to publish its full-year results). Growth this year is expected to be minimal. However, this means that margins are likely to improve as software will make up a larger proportion of the revenue mix. FactSet broker consensus is that IBM's operating margins will expand from 17.3 per cent last year to 18.4 per cent in 2025.

Cheaper than chips 

IBM has been a capital-light business since it transitioned to software and converts a lot of its profits into cash. In the year to December 2022, the company made $9.3bn in free cash flow on operating earnings of $8.3bn, and cash flow is expected to have risen 16 per cent to $10.7bn last year. IBM is guiding for free cash flow of over $11bn in 2024.

The market is taking note: IBM’s share price is up by a fifth year on year. However, it still lags the rest of the AI cohort, and trades on a forward price/earnings ratio of 17, compared with Accenture’s 29 and Microsoft’s 32. In terms of cash flow, IBM looks even more affordable, trading on just 12 times last year’s operating cash flow, while Accenture is trading on 24 times.

What happens now? So far, AI has mainly boosted the earnings of Nvidia, because it has driven demand for chips. Companies further down the supply chain have yet to reap the tangible rewards.

AI could still prove to be a dud, in which case demand for Nvidia’s chips will collapse and its share price will fall back down. Alternatively, AI will be the transformative technology everyone is expecting and demand for IBM’s consulting services will likely rise as companies take practical steps to modernise their operations.

Evidence suggests the latter is more likely. A survey from Morgan Stanley found that 68 per cent of chief information officers expect their investment priorities to shift when it comes to AI. Correspondingly, Morgan Stanley is forecasting overall IT spending growth to rise 73 basis points to 3.3 per cent next year.

IBM is seen as a relic of a bygone age of computing. However, Microsoft was in a similar boat not so long ago, and it is now competing with Apple to be the most valuable company in the world. IBM will be hoping for a similarly successfully second act.