Key Points
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IBM’s revenue growth slowed to a crawl in Q2 due in large part to hardware costs crowding out software spending.
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Even after the decline, IBM’s total returns have outperformed the S&P 500 during Arvind Krishna’s time as CEO.
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The stock’s P/E ratio has fallen to a multiyear low.
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International Business Machines (NYSE: IBM) just experienced one of the largest one-day declines in its history. That 25% drop on Tuesday came after CEO Arvind Krishna admitted that high capital expenditures on hardware had caused many companies to shift budgets away from software spending.
Such a sharp reaction from the market will understandably leave many investors wondering how to react. However, there are good reasons to treat this plunge as a buying opportunity.
Why IBM sold off
Admittedly, the negative reaction to Krishna’s statement was understandable. According to IBM’s preliminary Q2 results, the company’s revenue grew by just 1% year over year. That is well below its 9% increase in Q1 and brought revenue growth down to levels comparable to where IBM was before Krishna shifted the company’s focus to the cloud and AI.
Software is now IBM’s largest business segment, accounting for almost 45% of the company’s revenue in the first quarter. Additionally, the software segment’s annual growth rate fell from 11% in Q1 to just 5% in Q2.
Moreover, while IBM still operates an enterprise hardware business, its infrastructure segment experienced a 7% annual revenue decline in Q2. Hence, it does not appear to have benefited from the boom in hardware spending.
Why investors should stay confident
Nonetheless, the one benefit to investors is that the drop in this tech stock seems to have instantaneously priced in this particular challenge. IBM’s P/E ratio is now just 19, near its multiyear low. As recently as last fall, its earnings multiple was above 40, so this pullback represents a considerable discount.
Moreover, under Krishna’s leadership, IBM’s total returns have outpaced the S&P 500, indicating that he has earned investors’ confidence during his six-year tenure as the head of the company.
IBM Total Return Level data by YCharts.
Also, not all of the news in the preliminary report was negative. Red Hat’s year-over-year revenue growth in Q2 was 11%, indicating that bright spots remain in IBM’s software business.
Furthermore, the U.S. government is betting billions on quantum computing, and IBM has long led the way in that technology. Amid its partnership with the government, IBM in May announced plans for the construction of Anderon, the first pure-play foundry to build quantum wafers.
In addition to the $2 billion investment in the foundry ($1 billion of which came from CHIPS Act funds), it plans to invest $10 billion in quantum technology over the next five years. Such investments greatly increase the odds that IBM will be a major player in a technology that’s likely to drive innovation for years to come.
Buy IBM stock
The struggles in the software sector and IBM’s 1% revenue growth in Q2 are likely to continue weighing on the stock in the near term.
Fortunately, despite the sell-off, IBM stock has prospered under Krishna, and it appears that it is on track to continue outperforming in the longer term.
Additionally, the continued success of Red Hat and its investments in quantum computing should serve IBM well in the coming years. With this growth story now on sale at just 19 times earnings, Tuesday’s stock price plunge could be a blessing in disguise for new investors.
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Will Healy has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends International Business Machines. The Motley Fool has a disclosure policy.
