Shares of IBM (IBM) are struggling on Wednesday after the Wall Street Journal ran a report on the company's Watson computer, which needs to significantly improve results to reach the company's financial targets. Watson currently delivers $100 million in revenue, meaning it will need to grow exponentially to hit the 2018 target of $1 billion and 2023 target of $10 billion. Frankly, those revenue targets seem absurdly unrealistic. After a challenging 2013, it is critical that the company get growth initiatives like Watson off the ground and on track.
For the past decade, IBM has been pivoting from hardware to services with the growth of cloud computing challenging many of its existing businesses. Nonetheless, hardware is still a significant part of its business, and the company reported a truly stunning 40% drop in China hardware sales with sales in the emerging market down 22% overall in its most recent quarter. These trends have all been getting progressively worse, and I expect 2014 to be another down year.
Since 2008, IBM has been unable to grow revenue, and revenue has declined in six consecutive quarters. Importantly, during the last five years, IBM has spent over $17 billion on acquisitions. This means that IBM has a negative organic growth rate as competitors like Salesforce.com (CRM), SAP (SAP), and Oracle (ORCL) have taken share. Unlike in the past, CIOs have plenty of cloud and business service companies to choose from; it is no longer IBM and no one else. It used to be said that "hiring IBM never got a CIO fired." Now, the same can be said for a half-dozen companies.
Watson is a key initiative to get the company back on track. If the company is going to sustain its share repurchase plans out several years, it needs new drivers to make up for declining legacy businesses. Watson has shown the capacity to be very helpful in the healthcare field when diagnosing patients and is capable of learning. For instance, when it makes an incorrect diagnosis, it will alter how it reacts to a similar set of symptoms in the future.
To reach $10 billion in annual revenue, IBM believes that Watson can be used as almost a super-consultant to offer solutions to business problems, finance issues, etc. in addition to health care. Unfortunately, there are kinks to be worked out. Most notably, Watson isn't compatible with IBM's data center technology, which makes it far more difficult for IBM to regain its enterprise monopoly. Moreover, the company has been working from behind in the cloud revolution, leading to struggles in its server business. Other firms may develop similar offerings, limiting Watson's upside and margins.
IBM is trying to figure out a way to grow Watson 100 fold over the next decade, which is a monumental task. For a company that hasn't grown revenue in five years, that task may very well prove impossible. It also shows the challenge IBM's size poses. Even if it hit this target, Watson would only boost revenue by $10 billion in 2023 while the company generates over $100 billion today, meaning less than 1% annual growth. With current downward trends in IBM's revenue from existing business, IBM could very well have less revenue a decade from now than it does today even if Watson were to hit the target. To be truly successful, IBM will need to deliver three or four Watson sized successes. With less than $100 million in revenue, it looks like IBM will fail to deliver one.
IBM has been slow to react to the growth of the cloud and how it has changed enterprise IT spending. One reason for this is the company's dogmatic focus on its five year EPS roadmap. When companies focus on hitting near term earnings target, they often will push off investment or focus on financial engineering to deliver good short-term results with disastrous long-term consequences. In no sector is this truer than in technology where heavy investment is required to maintain a competitive advantage. IBM would be better off throwing out its guidance, focusing on its core business, and repositioning the company for growth. Instead, management continues to stick to its plan of pulling various levers, namely buybacks, to boost EPS while the legacy business is on fire and growth businesses underperform.
Many investors like Warren Buffett have jumped into IBM because the company buys back so many shares, which has pushed up EPS even while revenue has fallen. However, for the company to maintain the pace of buybacks, its business has to remain healthy. In IBM's case, a growing share of a shrinking pie may end up being smaller. Look at the last five years of results for operating cash flow, adjusted free cash flow (operating cash flow less all cap-ex and acquisition spending), and per share data:
Over this time, IBM bought back about 20% of its shares, yet from 2009-2012, OCF per share only grew 9.4% while FCF per share grew a lousy 4%. This slower growth rate has occurred thanks to a decline in OCF of 6% and a 10% drop in FCF. IBM has suffered a major drop in 2013 as revenue declines hastened, leaving investors with $11 in FCF, and shares are now trading at 17x FCF. Optimistically, the company will able to hold revenue steady over the next five years, which would make the stock's multiple extremely rich.
Essentially, the market is pricing in renewed growth at IBM, which I find highly unlikely. With this multiple, good news at Watson and other growth projects are baked in. With the current multiple, the company likely needs to grow revenue in the 2.5-3.5% annual range to generate a market-average 8% return to investors. That type of growth requires success at Watson. In reality, the risk to this project and others is to the downside with Watson generating a mere $100 million in revenue, which amounts to little more than a rounding error for IBM.
If Watson doesn't hit targets, you are left with a company that has declining legacy sever and services businesses, hardware issues overseas, and limited growth opportunities. These challenges will keep pressure on revenue, resulting in lower cash flow and EPS and declining share buybacks. IBM should trade closer to 13x FCF to reflect the challenges it faces, or $140-$150 per share. The Wall Street Journal Report re-emphasizes the fact that IBM is a must sell.