Risk is inherent to any investment. The question for investors is whether the risk is manageable, and whether the stock offers enough potential upside to offset a worst-case scenario. If investors pondered those points regarding IBM (NYSE: IBM) a year or so back, the answers would be slightly different from today.
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When IBM committed to transforming away from enterprise hardware and PC-related solutions to an emphasis on the cloud, data analytics, cognitive computing, and security, there was no shortage of skeptics. But as its strategic imperatives gain momentum, investors have determined that IBM is worth the risk, which would explain why its stock price is up 18% this year.
But like all stocks, IBM still faces challenges.
Image source: IBM.
First, the good news
IBM stock is on the rise because it's consistently delivering where it counts, and investors seem to recognize that its transformation is not just under way, but in full swing.
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With a recent change in financial reporting, IBM now reports its strategic-imperatives results as both unit sales and a percentage of total revenue. It's no wonder that, since Q2 2016, strategic imperatives were chugging along at an annual revenue run rate of $30.7 billion, equal to 38% of total sales.
It's no surprise that IBM's cloud push is leading the way in terms of its strategic-imperatives success. As of last quarter, IBM boasted an annual run rate of $11.6 billion in cloud sales, and even more telling was its nearly 50% jump in cloud delivered as a service, to $6.7 billion. It's this area in which IBM and one of its primary competitors, Microsoft (NASDAQ: MSFT), will continue to impress.
As fast and as large as the cloud market is expected to become in the years ahead, the hands-down leading driver of all that growth, excluding advertising, will be business process services and software-as-a-service (SaaS) solutions. Combined, the two cloud sectors will total an estimated $80.3 billion in sales this year. Coincidentally, those are both key components of IBM's -- and Microsoft's -- cloud plans.
The risks ahead
One of the few cloud providers on the planet that can rival IBM is the aforementioned Microsoft, though it's hardly the only one. With so much opportunity comes competition, and competition often translates to risk. That's particularly true when the competition includes some of the tech industry's biggest players, which certainly describes the cloud market.
As of last quarter, Microsoft boasted in excess of a $12.1 billion annual run rate of cloud-related sales, largely because of its SaaS offerings. Sure, its Azure cloud platform sales skyrocketed 102% last quarter and usage more than doubled, but that's merely a means to its SaaS end: Microsoft's 54% jump in Office 365 commercial sales is a testament to that.
IBM also faces the not-so-small matter of increased expectations from both investors and the Street. The impressive gains across its strategic imperatives units has been the impetus behind investors rising optimism, but if there's a hiccup of any kind in future quarters, the negative reaction would be immediate and harsh, to say the least.
As of last quarter, IBM was carrying over $44 billion in short- and long-term debt on its balance sheet, along with $10.6 billion in cash and equivalents. While not overly concerning for a company the size of IBM that generated free cash flow of $2.1 billion last quarter, the larger risk lies in why its debt has climbed: acquisitions.
IBM has already acquired 11 companies this year totaling more than $5 billion. The upside of all those deals is they have largely been in line with IBM's strategic-imperatives initiatives. But as Microsoft knows firsthand -- thanks to its failed smartphone ambitions, which ended with more than an $8 billion write-off -- successfully incorporating new technologies and people into an established firm can be a lot easier said than done.
So, how risky is IBM? Valued at just 11 times future earnings, paying a dividend of nearly 3.5%, and well on its way to implementing a successful transition, IBM has gone a long way toward minimizing the risk of investing in its stock.
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Tim Brugger has no position in any stocks mentioned. The Motley Fool owns shares of Microsoft. 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.