Background: I commented on International Business Machines' (NYSE:IBM) Q2 results as well as its presentation of those results in a July 18 Seeking Alpha article titled IBM And The Media Attempt To Obscure Its Declining Business Results. I followed that with an August 15 article asking Is it Time To Buy The Dip In IBM?.
My answer to the second article, written when the stock market was near its summer low and IBM was around $186, was:
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.
The first article was more thematic. It argued that IBM was spending too much effort on financial engineering and not enough on R&D, and also was overdoing the hard sell about the stock rather than simply stating that business was tough.
IBM's Q3: As I write this, IBM has sold off sharply after hours to about $176 following release of its third quarter results. Adjusted for an abnormally low tax rate, earnings were poor, and sales were down. Operationally, the quarter was difficult. However, IBM mostly kept up the bluster about how allegedly great it were doing and is going to do going forward. Unfortunately, IBM's pitch has begun to fall on more and deafer ears, as I discuss later.
Since sometimes the charts in retrospect "tell all," I'll start with a 2 and a 5 year chart of the stock.
Technical analysis - the rollover: First, a 2-year look courtesy of Yahoo! Finance:
Next, 5 years:
The above charts suggest a former outperformer that has run out of gas. This is a classic rounded top. There is no important support until around $130. Can the stock trade down that far on its own merits, absent a major general bear market?
The analysts: Yes, it might. A Rubicon might have been crossed, based on the reactions of analysts as evidenced by the tone of their comments and questions to IBM's management.
Here's Toni Sacconaghi on the conference call (Seeking Alpha transcript), as the second questioner:
I wanted to follow-up on the first question bit more broadly. I understand some of the specific issues this quarter around China, but if we kind of step back and think about what's been happening with IBM. Over a longer period recently you've had six straight quarters were revenue growth has been negative. You've missed consensus revenue expectations for seven straight quarters.
If it weren't for a huge tax benefit this quarter, it would have been a very significant EPS miss, which has occurred to IBM in the last couple of quarters and hadn't occurred in seven or eight years. So if we step back beyond the current quarter, we see a pattern of financial performance that is way out of whack with your historical model, lower revenue growth and operating profit growth that is dramatically lower but it's been buttress by tax rate and not including workforce rebalancing charge.
So my simple question is what's changed in the last six or seven quarters? Has there been a - I mean, less of a focus on execution that had to deal with the change in leadership at the top? Are you seeing new secular forces? I think it's very easy to explain away a given quarter, but six, seven, eight quarters in a row begins to make a trend. And so perhaps you can try and address what you think is happening more broadly and whether we should be thinking about a financial model that is more like 0% revenue growth and something less than double digit earnings growth on a sustained basis.
This is an extraordinary statement and set of questions. He summarizes my company-specific concerns expressed in my two Seeking Alpha articles on IBM.
Several other analysts pressed management to better explain its bullishness about the future. Here are some of the problems at which they were looking.
IBM overdid the huzzahs: A casual look at the beginning of the earnings press release looks fine:
o GAAP Results:
- Diluted EPS: $3.68, up 11 percent;
- Net income: $4.0 billion, up 6 percent;
- Gross profit margin: 48.0 percent, up 0.6 points;
o Operating (non-GAAP) Results:
- Diluted EPS: $3.99, up 10 percent;
- Net income: $4.4 billion, up 6 percent;
- Gross profit margin: 49.1 percent, up 1.0 points;
$23.7 billion, down 4 percent, down 2 percent adjusting for currency:
- Software revenue up 1 percent, up 2 percent adjusting for currency;
-- Key branded middleware up 3 percent; up 4 percent adjusting for
(Why branded middleware, which outperformed, is "key" but hardware, which lost money, is not key, is unclear.)
The summary concludes:
o Maintaining full-year 2013 Operating (non-GAAP) EPS expectation of at least $16.25; at least $16.90, excluding second-quarter workforce rebalancing charge.
I criticized IBM in my July article for asserting that severance costs should be broken out into a separate line item. They are costs just as much as salaries of employees who are not laid off are costs. In any case, IBM trumpets the rise in EPS in its text. It does not get around to disclosing a major reason for this rise until the bottom of page 3 of the earnings release:
Pre-tax income decreased 5 percent to $4.8 billion and pre-tax margin of 20.3 percent was down 0.2 points compared with the prior-year period. Operating (non-GAAP) pre-tax income decreased 4 percent to $5.3 billion and pre-tax margin was flat compared to the year-ago period.
IBM's tax rate was 16.0 percent, down 8.6 points year over year; operating (non-GAAP) tax rate was 17.0 percent, down 7.7 points compared to the year-ago period.
As Mr. Sacconaghi said, the quarter would have been a "very significant EPS miss" were it not for the tax benefit. Yet IBM in its prepared remarks summarized the quarter thusly:
Bottom line we delivered operating EPS of $3.99 which was up 10% year-to-year.
Say it ain't so, Watson! IBM has it wrong. The real bottom line for investors is that sales were down and would have been down more were it not for some acquisitions; and pre-tax profits were down as well. Also, IBM's excuse that "constant currency" results were better than GAAP results ignores the likelihood that the same factor that lowered the value of the Japanese yen-- money-printing- helped yen-denominated sales in Japan. "Constant currency" is a misleading excuse. If IBM happened to have a big operation in Venezuela, it might have a great quarter in constant currency bolivars, but what would that mean? Nothing.
In any case, only the small retail investor is fooled by IBM trying to avoid highlighting in the press release that its earnings missed expectations except for a large unsustainable tax benefit. A straightforward press release would have had a different tone from the start.
In order to keep this article focused, I'm not going to get tendentious and go through the earnings press release or prepared remarks for the conference call and pick apart IBM's evasiveness and hype. I'll simply point out that some analysts expressed skepticism about IBM's assertion that it expects to earn at least $20/share of operating income in 2015. That brings me to my big picture theme:
IBM errs in focusing on EPS: The focus on EPS by a date certain is one of the worst things a growth company can shoot for internally or mention to the public. Earnings per share in two years is almost meaningless to the long term stream of dividends that a company can or will provide to shareholders.
What if tomorrow, IBM researchers make a breakthrough that can catapult the company back to hardware growth and profitability, but to do so will require large capital and research expenditures that will make achieving $20 EPS in 2015 very difficult? Isn't the long term more important than a short term earnings number?
If earnings turn down and there is no tangible asset value, what is an attractive P/E for a technology stock? The answer is: no one knows until years go by. Why should investors in that stock be confident that they will ever get their principal back, much less a positive return?
IBM keeps cutting R&D. How can it grow that way? Aren't these R&D cuts being done to enhance short term EPS growth?
How many other great companies try to persuade investors that they will earn a certain amount of money some years hence?
What IBM is doing with its 5-year EPS plans raises the question of whether it is overly influenced by publicists and bean counters rather than inspired innovators and builders.
How low can the stock go?: At Wednesday's closing price around $187, IBM's market cap of $204 B was exactly double its projected 2013 sales. Given declining profits even in its Global Financial Services subsidiary, a black box that I stated in my last article could come under pressure, and given that between dividends and share buybacks, IBM has retained no profits for years, I am hard-pressed to find the stock attractive to new money purchases much above one times sales per share. That would put the stock somewhere around $90. Of course, there is much too much support for the shares for the stock to drop such a massive amount unless operations became much worse than they have become, so I don't think that $90 is a realistic target barring another liquidation event reminiscent of 2008.
Thus I look at IBM now rolling over on the charts despite a constructive chart for the market as a whole and think that somewhere between $90 and $180 is where the stock can drift or plunge down to on its own merits. Why not about half way between them? Price targets are arbitrary whether one derives them from charts, net present value models, or other means. IBM's negative tangible equity, relatively high debt levels, refusal to retain any earnings, and competitive difficulties on several fronts may make the stock unattractive to new buyers as high as 2X sales per share.
IBM may have become, or may be becoming, a "show me" company. Investors may begin demanding higher current dividends to account for the operational risks. Might the points Toni Sacconaghi made in the conference call begin to become received wisdom on Wall Street?
What if IBM is just a no growth company for some years to come?
Alternative view: IBM's glorious past will be prologue. Warren Buffett's keen eye for value should be respected. The analysts on the call are turning negative at the bottom of a cyclical business downturn for the company. IBM operates in secular growth areas. The Street will support IBM shares at high levels for the above reasons, so why sell just because of a difficult year or two?
All the above, and many more, are reasonable themes for patience with and bullishness on IBM's shares.
In the long run, I profess no crystal ball and wish the company well. IBM's name, patents, immense reach, etc. are clearly massive positives.
Conclusion: IBM's overarching focus on one metric, earnings per share, may have been a strategic error. IBM may have underinvested in future growth initiatives. Its multi-year policy of returning all its earnings to shareholders via dividends and share buybacks may have been well-intentioned. However, it may also reflect a company with diminished creativity, relying more on financial engineering than innovative hardware and software engineering than was optimal for its long run prospects.
IBM may be meeting not Waterloo but something murkier. A downward revaluation of the shares relative to the rest of the world's behemoths may be in order.
As always, numerous uncertainties exist as investors try to discern whether today's IBM continues to have the right stuff to provide positive returns to investors in the years and decades ahead.