IBM (IBM) is the one of the largest and oldest technology companies with revenues of nearly $100 billion a year. The company has across the board presence in major technology segments such as software, IT services and semiconductors with a massive patent portfolio. The company has performed quite well compared to other major software companies as the company's margins have shown a secular growth. But there is a big problem that the company has been facing over the last decade. The topline has remained flat even as margins have continuously expanded. But now the company has pretty much reached the end of the line in getting more margins from flat revenues (leading to the article's title).
IBM is also facing headwinds from newer technology trends such as cloud computing, virtualization etc. These new trends are lowering the overall prices of software and services and allowing the entry of new players such as Amazon (AMZN) into enterprise software, which is dominated by companies such as IBM. The company has also been facing a major challenge in expanding its topline during the last decade despite numerous acquisitions. Almost all of the earnings growth in the last decade has come by squeezing increased margins from existing businesses through increased outsourcing and a better product mix. The recent quarterly results marked the sixth straight decline in revenues and shows that the company has pretty much reached the end of substantial earnings growth. The company's stock has stagnated over the last year since I flagged the stock as a short, as investors have come to realize the challenges that IBM faces in growing its earnings.
a) Revenue falls across categories - IBM's revenue growth has mostly remained flat in the last decade compared to the sharp growth shown by its IT services competitors such as TCS, Cognizant Technology Solutions (CTSH), and Accenture (ACN). Note some of these competitors such as Wipro (WIT) and Infosys (INFY) were quite small earlier, but have now acquired the skills and the scale to compete with IBM in major multimillion dollar contracts. IBM was able to successfully copy the Indian off shoring model which resulted in a major increase in its margins. However, it was not able to grow its revenues which are now becoming a problem. IBM has pretty much reached the limit on the margin increase which means that growing earnings will be a big issue. You can grow earnings either through increasing your sales or through increasing the profit per unit sale. IBM on the other hand faces the prospects of a decline in sales and a flattening of margins. In the most recent quarter, IBM's revenues fell in IT services (down ~4%) and hardware (down ~17%) while increasing by a measly 1% in software. The chart below shows how IBM has fared poorly in increasing its topline in the last few years.
b) Hardware segment is a drag - IBM was able to successfully transform itself in the 1990s into becoming a major software/services company from a hardware focused one. Its main competitors such as Hewlett and Packard (HP) as well as Dell (DELL) realized the importance of this strategy a bit too late in the day. IBM still gets ~16% of its revenues from the sale of hardware such as servers and chips. But the company is facing a tough time making profits in these segments where other companies have become much stronger. IBM has been unsuccessful in trying to sell this segment as there are few buyers for this low margin business. IBM has also fallen behind Intel (INTC) and others in being a top semiconductor player. Its chips and architecture are increasingly being replaced by those of its competitors.
c) Losing marketshare in services - IT services has seen a big change in the last decade with the rise of Indian IT outsourcers such as TCS. These companies have increased their marketshare at a tremendous rate and are now becoming serious competitors to IBM and other US service companies. Though they face a temporary hiccup from USA's visa bill, they will continue to gain market share in the foreseeable future. Cognizant reported another great quarter despite facing macro headwinds and continues to remain my top pick in this space (read my earlier article). Even the other Indian IT companies such as HCL Technologies have given spectacular returns in the past couple of years. The rupee depreciation against the dollar and other currencies has further increased the competitive advantage of the Indian players. Note some of the Indian IT services companies have not been shown below as they are not listed on the US markets. But the growth of TCS and HCL has been almost as good as Cognizant Technologies. The size of these companies is still around 1/5th that of IBM, but they are growing much more rapidly and are becoming an increasing threat to IBM. HP and Dell are also focusing on expanding their software and services businesses which means more competition for IBM.
d) Margins don't have a lot of upside left - IBM has managed to grow earnings in the last few years by increasing its margins as revenues have more or less remained at the same level. The company has managed to increase its operating margin by almost 1% every year in the last 10 years. But the margin upside is limited as it has extracted most of the benefits of firing high cost employees in the USA and hiring low cost ones in India. This strategy has been the biggest margin driver for IBM and the company faces a tough time in increasing its margins. The potential sale or shutting down of the hardware may give a onetime boost to margins but the overall picture does not look pretty.
e) Dividends and Buybacks are not that good in reality - IBM is spending billions of dollars each year in buybacks and dividends. But in reality, this is not having much of an affect as the buybacks are mostly being used to offset the share dilution due to stock based compensation. The dividend yield of 2% is also not good, when you compare the dividend yield of other large technology players such as Microsoft (MSFT), Apple (AAPL) or Intel.
f) New entrants intrude into the enterprise space - The growth of new technologies such as cloud computing, analytics, virtualization etc. is a negative for IBM in my view. These trends are allowing new smaller players to enter the enterprise technology industry which was dominated by a few companies such IBM, HP, Microsoft etc. Amazon made major headlines by bagging a large $600 million CIA contact for cloud computing services. Startups in many areas are becoming big forces in the analytics and Big Data areas as well. Enterprises are using these new technologies to reduce their overall IT cost which means a problem for IBM.
Source - Zdnet
g) Valuation is not Cheap - IBM trades at a forward P/E of ~10x which does not seem expensive, however it is not too cheap given the risk that earnings growth may go down to single digits. IBM also does not have too much net cash like companies such as Microsoft or Apple. IBM has taken on debt to fuel its large buybacks and dividends.
Turning to the balance sheet, we ended the quarter with a cash balance of $10.2 billion. Total debt was $36.2 billion of which $25.8 billion was in support of a financing business, which is leveraged just over 7 to 1.
Source - Seeking Alpha
IBM Upside Risks
R&D strength - IBM is a technology company in the true sense of the word with a huge budget for research and development. The company has one of the largest patent portfolios in the world with nearly 70,000 patents. The company is also innovating in terms of using Watson for healthcare solutions and being aggressive in developing Smart Grid solutions. Like Xerox (XRX), IBM has been responsible for many important technology developments. The company is also growing aggressively in the big data and analytics space. However, the problem is that the company's overall growth is declining as the growth in the newer segments is cannibalizing the sales in its bread and butter categories.
IBM's stock performance has been quite bad over the last year and the stock has stagnated at the $180-200 level. In comparison the rest of the technology industry has been performing extremely well as can be seen in the chart below. If the stock market was not doing so well, I suspect that IBM's stock would have given a big loss to investors.
IBM's stock has heavily underperformed both the NASDAQ and the broader market over the last year as revenue stagnation becomes the top concern for investors. Though the company has continued to increase margins and earnings in the last few years, the company faces severe growth challenges in the future. The management does not have a convincing roadmap on growing revenues after almost 10 years of stagnation. The company faces headwinds from increasing services competition, hardware decline as well as new technology trends. IBM seems to be on the defensive with a recent ad acknowledging Amazon as a major competitor in cloud computing. I think that there are far better technology companies to invest in the technology space than IBM.