IBM - Don't Expect Anything Spectacular In The Coming Months

Oct.17.13 | About: International Business (IBM)

Shares of International Business Machines (IBM) sold off aggressively in after-hours trading. Investors and analysts are not happy that "Big Blue" reported a big miss on its quarterly revenues.

I do not expect anything spectacular in the short to medium term, yet long-term prospects should continue to look good as long as the company is taking the rapidly changing developments within the industry seriously, and continues to act upon this.

Third Quarter Results

IBM generated third quarter revenues of $23.72 billion, down 4.1% on the year before. Roughly half of those revenue declines are attributable to adverse foreign currency movements. Consensus estimates for revenues stood at $24.74 billion, implying that IBM missed consensus estimates by a full billion.

The company reported net earnings of $4.04 billion, up 5.7% on the year before. Diluted earnings per share advanced from $3.33 per share last year to $3.68 per share.

Non-GAAP earnings came in at $3.99 per share, beating consensus estimates by three cents as IBM benefited from lower taxes. CEO and Chairman Ginni Rometty commented on the third quarter performance:

In the third-quarter we continued to expand operating margins and increased earnings per share, but fell short on revenue. Where we had identified high growth opportunities and pursued them aggressively --- cloud, mobile, business analytics, and security --- we continued to show strong growth.

Looking Ahead

For the full year of 2013, IBM sees GAAP earnings of at least $15.01 per share. Non-GAAP earnings are seen between $16.25 and $16.90 per share, excluding a workforce rebalancing charge of $1.0 billion.

IBM is taking actions to improve execution in the emerging growth market units and underperforming hardware business. That being said, IBM is confident that it will reach its full year targets and its 2015 goal of achieving operating earnings of at least $20 per share.

Looking Into The Results

IBM saw its revenues fall by some 4.1%. IBM's main global technology service unit reported a 4.3% fall in revenues, coming in at $9.49 billion. Systems and technology sales fell by 16.6% to $3.25 billion. Only the global business service business and software business reported earnings growth of 0.4% and 0.6%, respectively.

Despite the fall in revenues, IBM managed to boost its gross margins by 60 basis points to 48.0% of total revenues. The company saw very strong reductions in selling, general and administrative expenses, which fell by 170 basis points to 22.2% of revenues.

While IBM didn't see a big one-time gain as it did last year, the bottom line was aided by lower provisions for income taxes, which boosted the bottom line.

IBM notes that a portion of these lower tax rates are structural, driven by a decrease in ongoing tax rates. Yet effective tax rates will bounce back a bit, as IBM had discrete benefits from deals with foreign tax audits.

Valuation

IBM ended its third quarter with $10.2 billion in cash, equivalents and marketable securities. Total debt stand at $36.2 billion, for a net debt position of around $26 billion.

Revenues for the first nine months of the year came in at $72.05 billion, down 4.2% on the year before. Net earnings fell by 4.4% to $10.30 billion in the meantime.

At this pace annual revenues could come in around $100 billion, as GAAP earnings could come in around $15-$16 billion.

Factoring in losses of 6% in after-hours trading, with shares trading around $175 per share, the market values IBM at around $192 billion. This values operating assets of the firm around 1.9 times annual revenues and 12-13 times earnings.

IBM pays a quarterly dividend of $0.95 per share, for an annual dividend yield of 2.2%.

Some Historical Perspective

Over the past decade shares of IBM have roughly doubled. As a matter of fact, shares traded as low as $75 in 2006 before they saw steady gains to levels as high as $215 last year. In the meantime, shares have nearly sold off some 20%, currently trading around $175 per share.

Between 2009 and 2012, IBM increased its annual revenues by a cumulative 10% to nearly $105 billion last year, although revenues are set to show a decline this year. Net earnings rose by nearly 25% from $13.4 billion to $16.6 billion last year. As IBM repurchased nearly one out of five shares outstanding over the time period, earnings per share saw a big extra boost.

Investment Thesis

Investors are not too happy with the drop in revenues. While IBM can partially blame adverse currency movements for the disappointing numbers, hardware weakness and soft emerging market performance hint towards execution issues.

Earnings in the hardware business fell by $1 billion so far this year, driven by dismal performance in China as adverse currency movement cost another $500 million.

Just like all companies operating in the wider industry, IBM is making the transition from focusing on hardware to software, replacing traditional IT infrastructures. Yet IBM still has a long way to go, as the third quarter was the very first quarter in which it generated cloud revenues north of $1 billion. Service sector could not offset falling hardware revenues as well, even as the service backlog continued to grow as IBM saw poor conversion into current revenues.

While IBM continues to hold on to its full year targets, analysts and the wider investment community are not happy, especially with the poor revenue developments. Yet IBM has done a great job at cutting costs to boost margins, while continued share repurchases continued to fuel earnings per share growth.

Over the past decade IBM has done well. It saw modest revenue growth, but coupled this with margin expansion and share repurchases, resulting in solid but spectacular earnings growth.

Today, the environment for IBM looks more challenging as more and more investors and analysts are questioning Big Blue's ability to reach its $20 earnings per share by 2015. This is as revenues are actually falling, or stabilizing at best. The ability to squeeze out higher margins going forward will be difficult, while IBM has already picked up quite some debt to finance share repurchases.

While IBM was quick to exit consumer electronics, the solid and profitable business market is coming under pressure by cloud developments. With a potential painful shift to the cloud coming up in the coming years, IBM is not that well positioned at the moment, while shares are trading at historical high levels.

Back in June of this year, I last took a look at IBM's prospects after it paid $2 billion to acquire SoftLayer to boost its cloud computing offerings. The deal is just a drop in the bucket for a firm the size of IBM, which targets $7 billion in cloud revenues by 2015, currently generating revenues at an annual rate just north of $4 billion. Note that even when IBM meets its 2015 target, cloud revenues make up just 7% of total revenues.

Back in June when shares were trading around $205 per share, I concluded that investors should not expect spectacular returns in the short to medium term, when in fact shares have lost some 10% ever since.

I applauded IBM's ability to constantly change in an evolving environment to stay competitive in the future. This will undoubtedly occur again given that IBM takes the Cloud seriously.

Trading around 12 times current earnings and 9-10 earnings for 2015, IBM still looks safe as the company should be able to overcome these hurdles. I do think prospects for short to medium returns look bleak given the current sentiment, yet the long term still looks good based on the valuation.

On top of that shareholders receive large cash flows consisting of a 2.2% dividend yield, and repurchases of up to 5% per annum, for a combined yield of around 7%.

I remain on the sidelines for now, but still seeing long-term potential on the back of an attractive valuation, as long as the company keeps evolving.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.