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IBM (NYSE:IBM) reported quarterly results after the bell on Tuesday that first looked to be pretty solid. However after looking deeper into results, it is clear that IBM remains a challenged company and is still an expensive stock (press release available here). Management manufactured another EPS beat with earnings of $6.13 compared to estimates for $5.99, but revenue was light yet again with its $27.7 billion in sales missing by $550 million. IBM continues to struggle in emerging economies, particularly China, and its legacy server business is still a drag. Investors will be better off investing elsewhere.

It may surprise investors that non-GAAP EPS could rise 14% year over year while revenue would fall 5% year over year. There are several reasons for this. First, IBM has been spending billions to buy back shares, which increases EPS by cutting the share count. Operating income was up 8% compared to the 14% EPS increase, which illustrates the impact of the buyback. Second, IBM has been slowly shifting toward higher margin service businesses, which increase profitability even when revenue is lower. These factors are positive reasons for the EPS beat.

Last though, IBM benefited from a lower tax rate, which is typically unsustainable. IBM's effective rate was 11.2% in the quarter compared to 25.5% last year. There were several one-time benefits relating to a favorable outcome in an audit. On an operating basis, IBM saw a tax rate decline of 13.5%. Let's calculate IBM's earnings absent this one-time benefit. Pre-tax operating income was $7.4 billion, so with a normalized tax rate, operating income would have been $5.59 billion, compared to the $6.6 billion that was reported. At this level, non-GAAP EPS would have been $5.21, which would have been a significant miss compared to estimates. Further, EPS would have declined 3% year-over-year compared to the announced 14% increase.

IBM bulls have liked to argue that the company can grow EPS even if its core business shrinks because it is buying back so many shares and moving into higher margin business. While these efforts are lowering the decline in earnings, this quarter was proof that earnings can still fall even when a company buys back a lot of stock. If you adjust for the one-time tax rate benefit, you can see that IBM actually missed on both the top and bottom line.

What drove the decline in IBM's revenue this quarter? First, IBM's "growth markets" continue to exhibit decline. Revenue in these growth markets was down 9% (down 6% adjusted for currency) from last year while BRIC countries were down 14% (down 11% adjusted for currencies). In these countries, we have seen governments push domestic tech companies and discourage purchases from American firms amid national security concerns thanks to the NSA leak. IBM's struggles in the emerging markets are continuing, which could significantly impair IBM's long-term growth potential. Moreover in developed markets like the U.S., many of IBM's legacy server businesses have struggled to compete against new cloud products, which is why IBM is entertaining a sale of it low-end server unit.

Further, IBM's efforts to move into higher margin businesses does not appear to be going that well. In fact, gross margins were down 0.1% to 51.7% in the quarter. Now on a non-GAAP, basis, margins were mildly higher at 52.6%, which was up 0.3% year over year. However, SG&A and R&D grew as a percentage of revenue by a combined 1.7%, outweighing the non-GAAP gross margin increase. IBM clearly has work to do to grow margins further. Without revenue growth, items like SG&A will continue to consume a higher proportion of revenue unless the company makes further job cuts.

For all of 2013, revenue was down 4.6% to $99.75 billion. This revenue total is also lower than what the company generated in 2008 ($103.6 billion). After a five-year period where many tech companies have grown tremendously thanks to the cloud and emerging markets, IBM is actually smaller. Now, IBM bulls say this isn't a problem thanks to the buyback and may take solace in management's 2014 forecast for at least $18 in non-GAAP earnings compared to analyst consensus of $17.97. This would represent 6.7% growth from IBM's $16.99 in 2013 non-GAAP earnings. Now, IBM has over $14.6 billion in buyback authority after repurchasing $5.8 billion in the quarter. At current levels, IBM could repurchase over 7% of shares, meaning that IBM is really forecasting no income growth at the $18.00 level.

Essentially, IBM is unable to grow, and it is using its buyback to drive earnings growth, but with the business in decline, there are times when the buyback is not enough. Moreover, IBM is starting to hit its buyback upper limit. Free cash flow was down 16.7% year-over-year to $15 billion, and IBM bought back $13.86 billion in stock and paid $4 billion in dividends, which is why IBM issued $3.2 billion in debt. Without free cash flow growth, IBM may eventually have to cut the pace of buybacks, and right now, free cash flow is in decline.

At Tuesday's close, IBM has a free cash flow yield of 7.3%. Given the headwinds the firm faces overseas and in its legacy business, I struggle to see a case for IBM growing free cash in 2014 and have concerns about longer term growth prospects. This valuation is awfully rich, and I would only be interested in IBM if there was a free cash flow yield of 8-8.5% to provide some protection against free cash flow erosion. At that yield, IBM would be trading between $163 and $173. IBM shares are correctly trading lower on this report, but I still view the stock as a sell. With negative structural shifts in the enterprise tech market, IBM has another 10% downside to fair value.

Source: IBM: At Least 10% Downside To Fair Value