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Better Buy: Microsoft Corporation vs. IBM

Leo Sun, The Motley Fool

Microsoft (NASDAQ: MSFT) and IBM (NYSE: IBM) are both considered "mature" tech stocks, yet the former outperformed the latter by a significant margin over the past 12 months: Microsoft rallied more than 40%, while IBM slid about 6%.

I previously compared these two companies in late 2016. At the time, I thought IBM's higher dividend and low valuation made it the better buy. I was clearly wrong -- so today I'll take a fresh look at both stocks and see if Microsoft remains a stronger investment than Big Blue.

A bear clashes with a bull.

Image source: Getty Images.

How do Microsoft and IBM make money?

Microsoft's ecosystem includes Windows, Office, Xbox consoles, Surface devices, the Bing search engine Cortana, and cloud services like Azure, Skype, and Dynamics CRM. Microsoft breaks its business into three categories: Productivity and Business Processes (Office, Dynamics, LinkedIn), the Intelligent Cloud (Windows Server, Azure, and other services), and More Personal Computing (Windows, search, and hardware).

37% of Microsoft's revenue came from More Personal Computing last quarter, 34% came from its Productivity and Business Processes, and the remaining 29% came from the Intelligent Cloud.

IBM's ecosystem includes IT services, business software, mainframes, various cloud services, and a financing unit. Last quarter, 45% of IBM's revenue came from its Technology Services and Cloud Platforms unit, which include its IT services and integration software.

23% of its revenue came from its Cognitive Solutions unit, which houses its software and transaction processing software, including its AI platform Watson. 22% came from its Global Business Services, 8% came from Systems (hardware), and the rest came from its Global Financing unit and other businesses.

The importance of cloud growth

Microsoft and IBM's businesses seem complex, but investors often measure both companies' strength by their cloud growth. Microsoft is pivoting away from its legacy software toward "commercial cloud" services -- which include Office 365, Dynamics, and Azure -- to bolster its top line growth. IBM is doing the same with its "strategic imperatives", which include its higher-growth cloud, analytics, security, mobile, and social businesses.

Microsoft and IBM both report their cloud services growth separately, although those newer businesses are scattered across their other units.

A graphical representation of cloud computing.

Image source: Getty Images.

Microsoft's total commercial cloud revenues rose 58% annually to $6 billion last quarter, and accounted for over a fifth of the company's top line. That growth was supported by 93% growth in Azure, 65% growth in Dynamics, and 42% growth in Office 365's commercial revenues. In the first three quarters of 2018, Microsoft's commercial cloud revenues rose 57% annually to $16.3 billion -- which indicates that it will easily top a $20 billion run rate for the full year.

IBM's strategic imperatives revenue rose 12% annually to $37.7 billion over the past 12 months, and accounted for 47% of its total revenue. During that period, its total cloud revenue (which includes private and hybrid clouds) rose 22% to $17.7 billion, as its more closely watched cloud services revenue grew 25% to $10.7 billion.

But which company is growing faster?

Microsoft and IBM are both making progress in the cloud, but the key difference is that Microsoft's other businesses aren't cancelling out those gains. Microsoft, which consistently reports positive revenue growth, generated double-digit sales growth over the past three quarters. Analysts expect its sales to rise 13% this year as its earnings climb 17%.

IBM only recently broke a multi-year streak of revenue declines with two quarters of anemic single-digit sales growth. The sluggish growth of its older IT services and business software units -- which are being propped up by favorable exchange rates -- continues to offset the growth of its strategic imperatives. As a result, Wall Street expects IBM's revenue to rise just 2% this year as its earnings inch up 1%.

That's why most investors are willing to pay a higher premium for Microsoft: Microsoft currently trades at 25 times forward earnings, while Big Blue has a forward P/E of 10. However, IBM's forward yield of 4.3% remains much higher than Microsoft's 1.7% yield.

The winner: Microsoft

IBM looks like the cheaper income stock, but it will likely underperform the market as its legacy businesses drag down its strategic imperatives. A stronger dollar could also cancel out the temporary forex-inflated gains at those older businesses. Microsoft's stock isn't cheap and its dividend is unimpressive, but it's a better bet than IBM at these levels. 

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Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool's board of directors. LinkedIn is owned by Microsoft. Leo Sun has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.