Shares of International Business Machine (IBM) are witnessing a renewed correction. A weaker emerging market performance and disappointing hardware sales resulted in a revenue miss as the company continues to struggle in order to stabilize its business.
Earnings growth is driven by share repurchases, which results in a more leveraged balance sheet and therefore limits drivers for future earnings per share growth.
Soft Fourth Quarter Results
IBM generated fourth quarter revenues of $27.70 billion, which is down 5.5% on the year before, and severely missed consensus estimates at $28.25 billion. Adverse currency movements took a toll on revenues, while revenues still fell by 3% in constant currencies. Income before taxes fell by 11.1% to $6.96 billion on the back of the decline in revenues and stable costs.
IBM managed to squeeze out a 6.0% increase in its annual earnings, reporting net earnings of $6.18 billion. Note that this is solely on the back of lower income tax provisions, as IBM cut its provision for income taxes by more than 61% to just $777 million.
As a result of share repurchases, Big Blue managed to increase diluted earnings per share by 11.7% to $5.73 per share, a penny ahead of consensus estimates. On a non-GAAP basis, diluted earnings per share rose by 14% to $6.13 per share.
Looking Into Greater Detail To The Numbers
IBM's revenues were a big disappointment. Systems and technology revenues, which is IBM's hardware business, fell by 26.1% to $4.26 billion which is very weak. Z mainframe sales fell by 37%, with more modest but still severe revenue declines reported for the other products within the segment. Global technology service revenues were down by 3.6% to $9.92 billion. The only modest bright spot was the 2.8% increase in software revenues, which totaled $8.14 billion. Very disappointing was the 6% drop in emerging market sales on the back of a 23% collapse in Chinese revenues on the backlash from the US spying scandals.
Despite the falling revenues, IBM hardly faced pressure on gross margins which fell merely 10 basis points to 51.7% of total revenues. Selling, general and administrative expenses actually rose by 1.2% in actual amounts, increasing by 140 basis points in terms of total revenues to 21.6%.
As a result, pretax margins fell by 160 basis points to 25.1% of total revenues. The lower effective tax rate of just 11.2%, compare to rates of 25.5% last year. This was the only reason why net profit margins rose. Net margins were up by 240 basis points to 22.3% of total revenues.
2013 In Review
IBM generated full year revenues of $99.8 billion for 2013, down 4.6% compared to the year before. Net earnings fell by merely 0.7% to $16.5 billion while diluted earnings per share rose by 4.0% to $14.94 per share.
This earnings per share growth was obviously not driven by operational growth, but by repurchasing shares to drive earnings per share. While IBM has access to roughly $11.1 billion in cash, equivalents and marketable securities, its debt pile has increased to levels just shy of $40 billion. This results in a net debt position of almost $29 billion. Note that this even excludes little over $16 billion in retirement and pension obligations.
Clearly IBM is not happy with the results, with the key executives foregoing the annual incentive payments for the past year.
For 2014, IBM continues to focus on the transformation, being aggressive in the areas which will drive growth and value. For this year, IBM targets GAAP earnings per share of $17 per share, and non-GAAP earnings a dollar higher. The company remains on track on its roadmap of generating earnings of at least $20 per share in 2015.
Living In Borrowed Times
Instead of focusing on revenue growth, IBM appears to be fully focused on earnings per share. While operational revenue and earnings growth stalled, the company resorted to share repurchases to drive earnings per share growth. In the period 2010-2012, IBM repurchased $35 billion worth of shares, while paying out little over $10 billion in dividends. This means that payouts were being roughly equal to earnings of $47 billion for the period. Note that this excludes cash being used for making acquisitions during this time period.
The same story occurred in 2013. Repurchases of $13.9 billion and dividends of $4.1 billion exceeded net earnings by some $1.5 billion. This excludes cash needed to finance $3 billion in acquisitions which only added to the debt position. All of this resulted in a steady built up in debt, which could be dangerous especially with declining revenues and earnings. IBM should be fine for now but maintaining its current trajectory for years forward is not sustainable.
Implications For Investors
IBM trades at fair multiples. As noticed before, IBM has struggled for a longer time to show meaningful growth, yet repurchases fueled earnings per share growth. Now there are few drivers left, with the financial power declining and continued pressure even in growth markets and the hardware business.
Trading around $180 per share, the equity in the business is valued just shy of $200 billion, or 10-11 times GAAP earnings for this year. This is fairly attractive, accompanied by a 2.1% dividend yield.
This is of course only true if IBM can maintain its targets for the remainder of the year and next year, while it can stabilize revenue growth. On the back of these struggles, shares managed to show any gains over the past year, despite the roughly 30% market rally. Despite the underperformance, shares are only 10-15% off their highs.
Shares are no obvious buy as the stabilization will still take time, prompting IBM to take another $1 billion in charges to restructure the business. Based on historical indicators, this implies another 10,000-15,000 job cuts could be in place. IBM remains committed to its targets, being comfortable to get back to mid-single digit growth rates in emerging markets by the end of this year.
At this point in time, it might still be too early to pick up some shares despite the past year's underperformance. Yet the valuation becomes more appealing, despite the built up in leverage. A stabilization of revenue trends could improve the prospects however going forward.