Introduction:After International Business Machines (IBM) announced Q2 earnings, I wrote a Seeking Alpha article titled IBM and the Media Attempt to Obscure Its Declining Business Results. As an admirer of IBM for decades, I was not happy to write a critical article of what for years was the large-cap U.S. growth stock, but we all have to adjust to changing realities.
Most articles about IBM are analytical; the company, its divisions, etc. have been studied thoroughly.
This article takes more of a contextual, questioning approach in discussing whether IBM is attractive to new money looking for an equity in which to invest.
Noting that management sold 17% of the 1.1 million shares it collectively owned within the past six months, and as usual purchased no shares, let's begin by noting operational trends.
Operations: IBM is struggling a bit. Q2 sales dropped two years in a row. This year, sales were down 3% from Q2 2012, or 1% when adjusted for currency fluctuations. All divisions had varying degrees of problems in Q2. This occurred in a global economy that experienced year-over-year nominal GDP growth, and one in which tech remains in a secular uptrend.
That the backlog of certain divisions increased does not say when revenues will occur, what margins they will produce, or what future sales and profit trends will be.
In its earnings release, IBM asserts that excluding a billion dollar "workplace rebalancing" charge from GAAP earnings was done because doing so is "most indicative of operational trajectory."
That's a questionable assertion; I take it as an important clue in deciding whether to be long the stock. Here's the reasoning.
When companies operate in secular growth fields and then fire and lay off large numbers of people two years in a row, that is indicative of a negative operational trajectory, or at least one that has failed to meet management's expectations. Repeated "one-time" large severance costs imply more than IBM would like us to believe about its trajectory.
The fact of repeated layoffs is actually indicative of operational trajectory, at least for part(s) of the company. Management appears to have it backwards. It could have avoided creating an impression that it focuses overly much on EPS as it defines it by using GAAP for this charge, and later breaks it out for investors to make of it what they will.
This was not the sole area where analysts were concerned. There were some pointed questions in the conference call. IBM's convoluted tax matters, discussed in my prior article, did not make every analyst happy.
Back to "earnings."
Defining "operational" or "one-time" expenses is a slippery slope. If company A hires IBM to consult on technology integration, that is also a one-time business win. Yet IBM wants us to put a generous P/E on earnings that flow from this "win," though when the job ends, that business is non-recurring (all else being equal). At the same time, "one-time" cash severance costs do not count, in management's view.
None of what IBM is doing or saying is close to being disastrous, but often these sorts of issues are tip-offs to ongoing problems. Because they do not show up on a spreadsheet, I pay attention and have emphasized it here.
The intangibles of a company include its corporate character and how straightforward it is about the current state of business; and whether it is oriented to the long term or the trading price.
The Street catches on: As mentioned, there was a skeptical tone to a number of the questions on the conference call, and Thomson First Call reports a slight drop in analysts' ratings on IBM stock. Last week, Mr. Garcha of Credit Suisse slapped a $175 price target on the stock when it was in the $190s. I concur with a key point he made.
The current exclusive focus on 'EPS based valuation is distorting.
My comments have nothing to do with his assessment of IBM's free cash flow, which may be controversial.
How should we value IBM?
Valuation concerns: IBM has been cutting R&D. Has that been to help it make its numbers? Its capital spending as a percent of sales is about half what it was in 1998. Is it spending too little in those areas?
If IBM has been skimping on R&D and capital spending, that should translate to a lower valuation of current earnings.
In the last 10 years, IBM's revenues have grown only 1.6% annually. That has translated to about 6% revenue growth per share given all the share buybacks (and 12% EPS growth). Every penny of the money used to invest in (speculate in?) IBM's own stock is money that was not spent growing the business. Are we now seeing the results of an excessive focus on financial engineering?
IBM is not the financial powerhouse that it once was, especially for those of us who remember the IBM of 3-5 decades ago. At the end of Q2, it had a bit under $7 B in working capital, against $26.3 B in long-term debt, a gap of $19 B. It's one thing for a cash-rich, debt-free company to make accretive buybacks, but IBM needs growth, not pro forma EPS. I now question the buyback strategy.
How should we value the future profits that come from business services and technology services, its two large service division?
These divisions, 64% of IBM's revenues last quarter, may or may not stay relatively high-margined for years to come. Though sales in those two segments combined were down over $500 M yoy, operating margins increased. That's interesting. Sales coming in below plan normally tie in to shrinking margins. How did margins increase on unexpectedly lower revenues? How sustainable are those increased margins?
These services divisions may not be strong growth drivers in the years ahead; sales and margins may both be challenged.
IBM may well be challenged to increase operating margins (OM). IBM's OM was 16.6% in 2003. Last year it was 25.1%. This sort of high OM is going to be needed to keep the stock selling near 2X sales per share. But difficult times for gross sales tend to harm margins.
Much praise is given in some circles to IBM's Global Financial Services, perhaps rightly so, given its profitability. However, I'm leery of financial services subsidiaries of non-financial companies.
It's difficult to know what P/E to give to GFS's profits. From IBM:
At IBM Global Financing we help clients acquire the latest technological solutions and services so they can innovate, grow and become smarter. We do this by providing you with robust financing and asset management strategies - helping ambitious visions become reality.
IBM Global Financing helps credit-qualified clients acquire the IT solutions that they need in the most cost-effective and strategic way. You can choose from a variety of IT financing options to address your unique requirements, while helping to manage your cash flow and assets.
What's the risk of competition harming this high-margined business? How unique is IBM in all aspects of the GFS business? I can think of many strong companies that would love to erode IBM's GFS franchise, some of them new to this business segment but with deep pockets and financial savvy. Of course, IBM has a pole position with GFS with many clients, but over time, I still wonder about the GFS profit picture.
One might also wonder about the possibility of a higher tax rate than that which IBM actually pays. (IBM has disclosed more than one tax dispute with the IRS.) More broadly, deficit-ridden governments might possibly crack down on strategies that tech companies routinely use to minimize their taxes, such as assigning intellectual property to an Irish subsidiary and valuing that IP very highly. Doing so lowers the profit that the subsidiary operating in a high-tax country shows when it sells anything utilizing that IP in that country.
A possible higher effective tax rate may not be "in" the stock.
To exemplify the above points, net profit margins for the entire company rose from 9% in 2004, to 16% last year. I wonder if they might settle down at, say, 12%, or even go back to 9%? If so, we can guess how investors would react.
In other words, competition plus creative destruction could go to work, just as they did years ago when IBM entered a long, difficult period.
Share buybacks, margin expansion and declining interest rates have created this phenomenon. All these favorable trends may reverse.
In light of the above observations and uncertainties, what's the "right" P/E for IBM's shares?
Given where P/Es have troughed in the past 2-3 years for a number of very strong global companies that have also had cyclical growth issues, an adequate margin of safety for IBM may exist at a notably lower P/E of GAAP earnings. Perhaps 10X?
However, because IBM is so focused on EPS, investors might look to non-earnings-based valuation metrics. I think that the 2:1 price:sales ratio is somewhat high right now.
IBM's shares do not come close to having the margin of safety that Ben Graham insisted upon. The price to prior 5-10 year inflation-adjusted earnings is high; the stock is trading at more than 7X stated book value and infinitely more than tangible book. That leaves the stock as a growth and inherent value (i.e. earnings power) story. But...
It is just when sales and profits turn down that Graham's margin of safety becomes most important to shareholders. Challenging times appear to be here for IBM; I'd want something closer to traditional Graham safety here before investing unless high-margined sales growth resumed.
Of course, Graham's most famous student, Warren Buffett, is a big long-term fan of IBM. That engenders respect, for sure. But he has been wrong or at least early from time to time.
- It's IBM. This implies a great deal.
- Warren Buffett is long IBM, for the long term.
Conclusion: IBM is priced as a growth stock, but lately it has been acting like a cyclical one. It also is not priced as a value stock.
There are enough questions about the sustainability of margins, and whether management is overly focused on making its EPS numbers, that I think that it makes sense to watch IBM stock but not buy it.
If management begins buying the shares, likely I will do so also.
Additional disclosure: Not investment advice; I am not an investment adviser.