Lately, a lot of people talk about the troubles of IBM in the investment community. Since April, the company has been in a slow but steady sell-off mode where its shares fell from $216 to $177. Still, you see many people claiming that the company is still overvalued. Is IBM really doing that bad at the moment that it is selling off while the rest of the market rallies near or at all-time high levels (mostly thanks to the money-printing activities of the central banks around the world)?
In the last quarter, IBM was able to earn $3.99 per share on revenues of $23.7 billion, beating analyst expectations on net earnings but missing on revenue expectations. The company's revenues were down about 4% year-to-year but its margins were up during the same period. Basically, the fall in revenues was more than offset by an increase in margins. More importantly, the company reiterated its earlier guidance of $16.90 per share for the full-year.
The biggest challenges of IBM
Currently, the biggest worry for IBM seems to be the company's ability to grow in the Asian market as well as reversing a sharp decline in hardware sales. In the last quarter, the company's revenues in the Asia-Pacific region were down by 15% and its global hardware revenues were down by 17%. These two items were more than enough to spook the investors who were already selling their shares off well before the earnings report was announced.
As IBM saw several quarters of revenue declines in a row, most of its current earnings-per-share growth seems to come from cost cutting measures that improve the margins as well as share buybacks which reduce the dilution and effectively make each share more valuable. While IBM's cash flow generation is strong enough to support major buybacks for the foreseeable future, a company can't grow its margins forever by simply cutting costs. Since 2009, many companies improved their margins greatly by laying-off a great number of employees and improving their synergies overall; however, this practice only helps so much if revenue growth doesn't follow.
If IBM wants to keep growing its revenues, it will have to focus on growth markets like China. Ironically enough, most of the company's revenue declines seem to come from these markets in the recent quarters. In the last quarter alone, IBM's revenues in China were down by 22% and the company's hardware revenues in the country were down by 40%. This is a trend that needs to be reversed by the company if it wants to go back to the growth mode.
IBM has to adapt and innovate quickly
Years ago IBM sold its personal computer business and moved on to become a software, service and consulting company. This saved the company from a lot of troubles we see today with companies like HP (HPQ) and Dell (DELL) who depend greatly on the PC market. IBM was always seen as one of the smartest technology companies everyone looks up to because it was able to transform its entire business within such a short time and became more successful each year. After all, it was one of the few technology companies that Warren Buffet felt comfortable enough to invest his money in. For the last couple years, things have been changing and the company has been dealing with execution problems as well as the market challenges.
The markets where IBM operates move and change very rapidly. Technology is shifting towards mobility, and it is becoming highly dependent on "big-data." Now everything seems to be interconnected through the social media and cloud, and we even see fridges and ovens that come with a Twitter (TWTR) application. In this fast pace environment, IBM has to keep innovating quickly and it also has to compete on price, especially in markets like China where local companies seem to get things done very cheaply mostly thanks to the government subsidies offered in those markets.
One of IBM's most successful lines of business has always been its service segment. This year, this segment is seeing a revenue decline of 1% after adjusting for currency exchange rates. It's interesting to note that the company's service segment has a backlog of $141 billion and this backlog continues to grow at a mid-single-digit rate. It is unfair for the company to see revenue decline in an area where its massive backlog keeps growing and this points to some execution problems.
IBM engages in some relatively newer initiatives that continue to see growth but this might not be large enough to offset the company's revenue declines in other areas. For example, in the first 9 months of this year, the company's, Smarter Planet product line saw a revenue increase of 20%, the Business Analytics segment saw a revenue increase of 8% and the Cloud segment saw a revenue increase of 70%. The company is also changing its product mix in favor of services and software and away from hardware. In 2000, 35% of IBM's net income came from hardware, 38% came from services and 27% came from software. As of this year, hardware accounts for about 14% of the company's net income (even though it still accounts for 40% of the company's revenues in some emerging markets such as China); whereas, 41% of the profits come from services and 45% of the profits come from software. By 2015, software will account for 50% of the profits and hardware will account for hardly anything for the company.
Organic growth vs financial engineering
In the last 12 months, IBM generated $16.1 billion in free-cash flow, spent $11.1 billion on share repurchases and $4.0 billion on dividends. Currently the company has about $10 billion in cash balance and it intends to return most of its cash generation to the shareholders in shape of dividends and buybacks. Many people see IBM's practice as "financial engineering" as the company hopes to earn $20 per share by 2020 with the help of share buybacks that keep reducing the dilution. Some people are completely fine with the idea of growing EPS by repurchasing shares and some people want to see organic growth. Those that are looking for organic growth probably sold their IBM shares in the last few months once they realized that most of the company's growth won't be organic in the near to medium term.
If IBM will not be seeing much organic growth in the near-to-medium term but the company will be seeing EPS growth through repurchases, then how do we value the company? Do we value IBM like a growth company or a value company? This debate will probably go on for a long time in the investment community. When we consider that IBM currently trades for 12.5 trailing earnings, 10.4 times forward earnings while the industry average is 15.6 and S&P average is 17, we can clearly see that the market treats IBM as a value company rather than a growth company. The company's price to cash flow ratio is pretty attractive at 11, especially when we compare it against the industry average of 14 and keep in mind that the company returns most of its generated free cash to investors. Even if you don't appreciate IBM's lack of recent growth, you have to appreciate the company's ambitious buyback program.
So, are things that bad for IBM? Well, the company is having trouble with growing its revenues and it's seeing a lot of revenue declines in markets where it is supposed to see most revenue growth, which is ironic. On the other hand, IBM can turn things around as it has the ability and resources to do so. The company has a nice backlog, and if it can solve some of its execution problems, it can go back to the growth mode. While IBM has its own troubles to worry about and deal with, many of those troubles are already baked in the company's share price and downside should be limited from here. Also, keep in mind that there are very few companies in the technology sector that aren't riddled with troubles as we speak. Even the "mighty" companies like Apple, Intel and Microsoft are having growth problems and this is a problem the industry will have to deal with at some point.