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Investopedia describes a value trap : "A stock that appears to be cheap because the stock has been trading at low multiples of earnings, cash flow or book value for an extended time period. Stock traps attract investors who are looking for a bargain because these stocks are inexpensive. The trap springs when investors buy into the company at low prices and the stock never improves."

This article will explore why IBM may appear fundamentally cheap, which attracted legendary value investor Warren Buffett to buy a filing sized position, but faces substantial risks to the present cash flow model.

IBM's past decade of stock appreciation reviewed

IBM has done an excellent job of insulating themselves from the intense competition in the IT hardware area over the last decade, by investing heavily in the less capital intensive areas of service and software.

IBM has leveraged their bluest of blue chip name around the world thru IT service contracts, which facilitates the sales of high profit software.

Meanwhile, IBM has greatly reduced its exposure to the capital intensive hardware area, and completely exited the cutthroat consumer electronics areas.

IBM has been able to redirect the capital from the hardware investments to stock buybacks, which has greatly reduced the outstanding share count, and increased the share price by about $100 share.

Meanwhile total revenues were 89.13 Billion at yearend 2003, and have only grown to 104.5 Billion at year end 2012. Research and Development spending was $5.077 Billion in 2003, and was only $6.3 Billion in 2012.

IBM has shrunk the diluted outstanding share count from 1.756 Billion shares at year end 2003, to 1.155 Billion at year end 2012.

Most of the cash for stock buybacks is dependent upon the free cash flow generated from the service and software areas.

Therefore, the bulk of the following analysis will focus on the prospects for IBM's traditional service and software businesses.

IBM is facing strong IT industry headwinds, which could substantially reduce the profitability of its traditional service and software areas.

The Cloud services area is a significant paradigm shift in IT, in my opinion. While IBM has weathered a few similar type shifts over the last few decades, almost every prior episode caused significant damage to IBM's traditional IT businesses.

IBM has been very successful in the outsourcing of IT services, mainly because of their bluer than blue reputation. Once a large company outsourced to IBM, it became very hard for smaller companies with less sterling reputations to steal that business away, even with the use of lower pricing.

The cloud has a good chance of completely changing the IT services area for IBM and most of its traditional competitors.

The greatly reduced price of connectivity eliminates requirement for main IT equipment on site.

The first manifestation of reduced connectivity costs helped IBM provide all the required IT equipment at their own sites, rather than at client's sites. But these deals were essentially a company agreeing to sell their equipment and IT sites to IBM, in exchange for long term management contracts. These long term IT services contracts really locked customer companies into dealing with IBM for long periods of time. Even when the cost of IT equipment was falling dramatically along with the price of connectivity, IBM was still receiving the same long term payments.

Cloud service companies such as Amazon, Google, Microsoft, Verizon, etc. can now better compete with IBM for IT service contacts. Instead of IBM being able to charge premium prices for customized IT services, customer companies can now buy those same services as a commodity service.

The commoditization of an industry usually reduces profitability

Amazon (NASDAQ:AMZN) is willing to gain market share by accepting extremely low margins. Verizon (NYSE:VZ) is a key telecommunications infrastructure owner, so they have an advantage over a company that must contract for connectivity services. Google (NASDAQ:GOOG) is the preeminent internet services company, and has a long term cloud vision, which can be funded by its extremely profitable advertising based businesses. Microsoft (NASDAQ:MSFT) still has an extremely profitable monopoly on PC software, and will spend heavily to maintain its business customers, which means competing in cloud services. Salesforce.com (NYSE:CRM) is a pure play in cloud services, so will obviously continue to compete aggressively. Oracle (NYSE:ORCL) also realizes that they too must spend heavily to compete in the cloud delivery of their software.

All these potent new competitors entering into the IT services industry will most likely reduce IBM's margins and profitability, in my opinion.

Cloud delivery will reduce upfront software profits

While IBM has some software as a service businesses, or SaaS, the bulk of their software revenues and profits come from traditional upfront sales, in my opinion.

While SaaS provides long term recurring revenues, the switch over from upfront sales usually causes a significant hit to profitability over the intermediate term. While IBM will be able to continue cutting costs, (firing workers) with increased Cloud delivery, the reduced revenues and severance charges are damaging to intermediate profitability.

The internet in general, and cloud services specifically, allows smaller software companies to more easily compete against giants like IBM. In the past a new software company needed more funding, so they could hire a sales force. Whereas now they can contract with a cloud services company for SaaS revenues, without being forced to hire salespeople.

Conclusion

With potent new competitors entering the IT services area, it is hard to see how this IT paradigm shift will be favorable to IBM.

The growth of cloud services generates other negative trends in IBM's traditional software businesses, which have only been exacerbated by aggressive new competitors, such as Salesforce.com.

It is clear to me that both of IBM's main business segments are facing large negative headwinds, which greatly increases the possibility for worse than expected profitability.

While IBM will probably not face quickly collapsing markets, similar to what happened to American icon Eastman Kodak, there is a strong potential for complacent investors to get trapped in a perceived value situation.

Source: Is International Business Machines A Value Trap?