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Business could not be any worse for IBM (NYSE:IBM). Despite cutting costs and staff levels over the last few years, results continued to stagnate. IBM even said again it will take a workforce rebalancing charge (reduce its workforce) of about $1 billion. The company was still confident it could deliver $20 per share in 2015, monetize Watson's technology, and continue its strong performance for WebSphere this year. Yet major headwinds confound IBM. Investors need to exercise caution with IBM, especially with weak performance in China likely to continue. IBM's shares yield a dividend of 2.15%. This dividend income pales in comparison to other stagnant companies like Intel (NASDAQ:INTC), whose shares yield 3.67%.

There are 3 reasons the drop in shares of IBM is not yet over.

1) R&D rates did not keep pace with business growth

In the midst of reducing workforce levels and minimizing R&D expenses, IBM chose to grow sales by acquiring companies. Debt grew steadily between fiscal 2010 and 2012. By the quarter ended September 30, debt was $28,478M:

12/31/2010

12/31/2011

12/31/2012

9/30/2013

Long Term Debt

21,846.00

22,857.00

24,088.00

28,478.00

Change in Debt

4.6%

5.4%

18.2%

Source: Kapitall

R&D (research and development) expenses did not increase much since 2011. IBM still managed to raise revenue in 2011, but this fell in the last two fiscal years:

12/31/2010

12/31/2011

12/31/2012

12/31/2013

R&D Expense

6,026.00

6,258.00

6,302.00

Change in R&D

3.8%

0.7%

Net Sales or Revenues

99,870.00

106,916.00

104,507.00

99,751.00

Revenue Growth

7.1%

-2.3%

-4.6%

Source: Kapitall

Quarterly R&D expense as a percentage of revenue was also in the single digits:

3/31/2013

6/30/2013

9/30/2013

Net Sales or Revenues

23,408.00

24,924.00

23,720.00

R&D Expense

1,644.00

1,548.00

1,468.00

R&D as % Sales

7.0%

6.2%

6.2%

IBM sold its server division to Lenovo (OTCPK:LNVGY) and increased a focus on the Watson group. These moves imply IBM will focus on software sales over the next few years. Tibco Software (NASDAQ:TIBX) touts itself as selling real-time analytics solutions for big data, cloud mobility, and social (among other things), spends a significant amount on R&D:

2/28/2013

5/31/2013

8/31/2013

11/30/2013

Net Sales or Revenues

237.79

245.85

270.86

315.45

Research and Development Expense

41.62

42.57

43.39

43.34

R&D as % Sales

17.5%

17.3%

16.0%

13.7%

IBM underperformed relative to Nasdaq Composite index

IBM Chart

IBM data by YCharts

2) Weak Watson sales expected

IBM plans to invest $1B in a new Watson unit. The unit is responsible for commercializing cloud delivered cognitive innovations. To speed development, IBM is open to investing up to $100M in venture investments that relate to IBM Watson development. IBM believes the Watson unit will add to the $20 EPS in 2015, but investor skepticism is warranted. Ongoing staff reduction will make it harder for IBM to assign resources that the Watson unit needs. Unless IBM plans to hire new outside talent, revenue from Watson may disappoint.

Natural language capabilities are a core offering from Nuance Communications (NASDAQ:NUAN), but it reported disappointing results last quarter. Nuance shares are down 18% over the past six months:

IBM Chart

IBM data by YCharts

3) Services revenue weakened

Revenue in the fourth quarter for the services segment stagnated. Global Technology Services revenue dropped 3.6% year over year to $9.9B.

There were some bright spots for IBM last quarter. Data analysis revenue added $15.7B in revenue, while Cloud related businesses accounted for $4.4B in revenue.

Bottom Line

IBM should earn $17 per share (GAAP), which values its shares at 10.4 times forward earnings. This makes its shares appear inexpensive compared to Microsoft or Intel, whose forward P/E is 13 and 12, respectively. IBM will meet earnings expectations by balancing its costs in 2014, but its businesses face significant challenges. Revenue from China dropped 23%, due mostly to hardware. Investors should anticipate a slow recovery in this region. China began the year with weak PMI (Purchasing Managers' Index) figures. Capital flight away from emerging markets will also hurt IBM's businesses in those regions. For all of these reasons, investors should cut their exposure to IBM.

Source: 3 Reasons To Avoid IBM