Will IBM Stock Surge in 2018? 1 Analyst Thinks So

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Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

Is IBM (NYSE: IBM) stock cheap enough to buy?

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IBM has looked cheap for a long time. According to data from S&P Global Market Intelligence, this titan of the tech world has traded at an average price-to-earnings ratio somewhere in the midteens or lower -- and it's stayed there for more than a decade. The fact that IBM has stayed so cheap for so long has earned IBM something of the reputation of a value trap among investors. Thus, even at a current P/E ratio of 12.6, investors remain leery of investing in IBM.

But could 2018 be the year that that all changes? Is this time different?

Canadian investment banker RBC Capital thinks so. Hailing the "return of the machine," this morning RBC announced it is upgrading shares of IBM stock to outperform and assigning the $159 stock a price target of $180 a share. Here are three reasons why.

1. Margins and mainframes

As RBC explains in a note recapped by StreetInsider.com (requires subscription) this morning, there are "a host of cyclical and secular levers that should enable share performance through 2018." Chief among these are "a return to gross margin stability coupled with revenue growth in 2018."

This would come as a welcome relief to IBM investors. As those who've watched this stock for a while will recall, IBM's revenue has been shrinking, not growing for more than half a decade, falling steadily from the $106.9 billion in revenue recorded in 2011 to just $79.9 billion in 2016 (and $78.4 billion over the past 12 months). And yet, according to RBC, z14 mainframe revenue for IBM will hit the peak of its cycle in the December and March quarters (fiscal Q4 2017 and Q1 of 2018).

Margins, too, have been suffering. After rising more than 300 basis points from 2011 to 50% in 2014, gross profit margin proceeded to tumble thereafter, reaching a recent low of 46.3% over the past 12 months. On the bottom line, net profits have fallen even longer -- from 17.2% in 2013 to 14.7% over the past year.

Improved revenue from better mainframe sales, however, should enable IBM to better use all of its production capacity, and boost profit margins on those sales -- bolstering profits on the bottom line.

2. More revenue from "hybrid IT"

A second revenue driver that RBC sees kicking in for IBM this year hails from "hybrid IT" -- businesses spending to complement their in-house IT resources with cloud-based services. RBC notes that at least three IBM competitors in this arena -- NetApp, Red Hat, and VMware -- are seeing their revenues benefit from "underlying demand trends" in hybrid IT. While RBC isn't going so far as to predict that IBM will outperform these nimbler rivals, the analyst argues that "given IBM's position as a key enabler for Hybrid IT for large enterprise, the company should at least see revenue growth in-line to modestly below IT spend patterns (~1-3% growth potential)."

3. Help from abroad

One final note: For three years now -- approximately the same period of time that IBM's profit margins have been sagging, and accounting for much of the time that its sales growth has stalled -- IBM has suffered from foreign exchange headwinds in the form of a strong U.S. dollar. A strong U.S. dollar may sound like a good thing, but for corporations, it that makes selling U.S.-origin goods and services to foreign buyers harder, because they look more expensive relative to foreign-origin offerings.

In 2017, however, exchange rates finally broke in IBM's favor, and dollar-denominated sales now look approximately 10% cheaper than they did for much of this expensive-dollar period. RBC estimates that high exchange rates shaved about 1 full percentage point off of the sales that IBM would have recorded in a more favorable currency environment. In 2018, however, RBC believes a reversal of this dynamic could add about 30 basis points to IBM's revenue growth rate.

What it all means to investors

So let's sum up: Between mainframe cycle sales growth, 2%-ish sales growth from hybrid IT, and about 30 basis point in extra revenue from currency effects, RBC appears to be predicting something on the order of 3% or better growth in sales at IBM this year. That's not a lot, but it would still be an improvement over the five straight years of sales declines that IBM investors have suffered through this past decade.

Combined with even a modest improvement in margins, this should suffice to produce the sub-5% growth in earnings that analysts, on average, are looking for IBM to produce over the next five years (according to S&P Global data). Combined with IBM's rich 3.9% dividend yield, this has RBC thinking that IBM stock is a good bet to outperform in 2018.

To this I'd add that for three years running, IBM has consistently produced free cash flow superior to what it's reported as net earnings on its income statement. (For example, over the past 12 months, reported earnings of $11.3 billion fall short of the $11.6 billion in real cash profits the company has produced.) This trend has me inclined to agree with RBC that IBM is a good bet to outperform. Before I go all in on the stock, though, and actually endorse IBM as an investment, I'd really like to see management use some of that cash flow to pay down IBM's heavy debt load.

With $16.1 billion worth of cash, long-, and short-term investments on its books, you see -- but $41.3 billion in long-term debt -- IBM stock is actually about $25 billion more expensive than its stock appears to be based on market capitalization alone. If and when I see IBM whittle away at that debt, though, and if and when the predicted growth appears, I promise to give IBM another look.

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Rich Smith has no position in any of the stocks mentioned. The Motley Fool recommends VMware. The Motley Fool has a disclosure policy.