1 Simple Reason International Business Machines Corp.'s Profits Could Rise

By Markets Fool.com

International Business Machines recorded about $92.8 billion of revenue during 2014, not much more than the $91.1 billion of revenue the company managed in 2005. Despite this lack of revenue growth, profits have soared, with the company's operating income nearly doubling over the past decade.

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The market seems to be concerned with IBM's lack of revenue growth, with the stock down about 16% over the past three years, compared with a 56% gain for the S&P 500 during that time. But for the same reason that IBM was able to grow its profits during the past decade despite stagnant revenue, the next decade could bring even more earnings growth. The reason: software.

The shift to software
Over the past decade, hardware has become a decreasingly important part of IBM's business. That's not to say that IBM's hardware doesn't matter anymore -- one of IBM's key strengths is its ability to deliver integrated solutions involving hardware, software, and services. But as a percentage of revenue, hardware doesn't contribute nearly as much as it used to.

Taking the place of hardware has been software. In 2004, IBM generated $15.1 billion in revenue from software, or about 15.7% of its total revenue. In 2014, $25.4 billion was derived from software sales, accounting for 27.4% of IBM's total revenue. As IBM shed unproductive businesses and shifted resources over the past decade, software has grown in importance.

Why is this important? Because software is by far the most profitable part of IBM's business, and it's getting more profitable every year. In 2004, IBM generated $4.5 billion in pre-tax income from its software business, good for a 26.9% pre-tax margin. In 2014, $10.7 billion of pre-tax income came from software, with a pre-tax margin of 37%.

So while total revenue has barely budged over the past decade, IBM's constant shift toward higher-value products, particularly software, has pushed its profits higher.

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Software-heavy strategic imperatives
Cloud computing has required IBM to transform itself yet again, and the company's strategy going forward revolves around a few "strategic imperatives." The four main areas IBM is focusing on are cloud, analytics, mobile, and security, and the company has shifted $4 billion of spending to these initiatives. In 2014, these strategic imperatives generated $25 billion in revenue, and by 2018 IBM expects this number to rise to $40 billion.

This growth in revenue will partly counteract falling revenues elsewhere, and IBM expects just low-single-digit revenue growth annually. But in 2014, revenue from these strategic imperatives was about 50% software, with another 40% coming from services and the rest coming from hardware. As these initiatives grow, IBM's revenue will continue to shift further toward software, driving higher margins even with extremely slow overall revenue growth.

IBM's strategy today is really the same strategy that the company has been using for years: Constantly shift the business toward higher value, focusing on areas where IBM can gain a competitive advantage. Software was the key to IBM's growth over the past decade, and it will be the key to IBM's growth in the next decade as well.

Get it while it's cheap
With IBM capable of growing its earnings at a faster rate than revenue in the coming years thanks to its continued shift toward software, the stock offers a tremendous value to anyone who can look past the declining revenue. IBM trades at less than 11 times last year's earnings, and its dividend has become one of the best in tech, yielding 3.1% with plenty of room to grow.

IBM doesn't need to grow by leaps and bounds in order to justify this valuation, and its buyback program will continue to take advantage of the pessimism surrounding the stock, rewarding investors in the process. In the long run, IBM looks like a great investment at these prices.

The article 1 Simple Reason International Business Machines Corp.'s Profits Could Rise originally appeared on Fool.com.

Timothy Green owns shares of International Business Machines. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.