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Summary

  • IBM shares have drifted lower after reporting in-line earnings.
  • IBM revenues continue to decline on a year-over-year basis due to cannibalization from the cloud and weak results in emerging markets.
  • With limited sales growth, investors should wait for a free cash flow yield of at least 8%, which is roughly $175 per share.

On Wednesday afternoon, IBM (NYSE:IBM) reported first-quarter results that were roughly in line with analyst expectations (financial and operating data available here). However, some investors were expecting more, and shares dropped 4% in the after-hours session. Shares are sitting at roughly 10-month highs, so this quarter provided a solid opportunity for some profit taking. After reviewing the quarter, this action is fully merited, as IBM suffered a year-over-year decline in revenue for the eighth consecutive quarter. With limited growth prospects, IBM shares are fully valued at current levels, and investors should look elsewhere for value.

In the quarter, IBM generated operating (non-GAAP) EPS of $2.54 on revenue of $22.5 billion. Analysts were looking for $2.54 on sales of $22.9 billion. While earnings beat estimates, IBM was light on sales. Importantly, sales were down 4% year-over-year. Unless IBM can show an ability to grow revenue, future profitability targets may prove to be too optimistic. Now on a constant currency basis, revenue was only down 1%. Currency, though, will likely be a headwind for the majority of 2014. If the ECB launches a QE program, the euro could take a hit against the dollar, and slowing growth in emerging markets has hit their currencies.

On the positive side, gross margins did expand by about 130bp to 46.9%, though IBM's strategic shift is responsible for much of this growth. IBM showed some growth in software revenue (up 1.6% year-over-year), which has fantastic gross margins of 87.5%. IBM's hardware business continues to face major problems with systems and technology revenue dropping 23%. At the same time, this unit's gross margin dropped dramatically 27% to 32.3%.

Simply put, cloud-based offerings are cannibalizing some of IBM's legacy hardware business. IBM is trying to keep these customers with cloud offerings of its own, but the industry is highly competitive, with Amazon (NASDAQ:AMZN) and Microsoft (NASDAQ:MSFT) having significant footholds. IBM notes that cloud as a service revenue doubled year-over-year, which seems like a great accomplishment. However, growing off a very small base can lead to significant percentage gains. Cloud as a service has a run rate of only $2.3 billion, which will account for about 2.5% of IBM's 2014 revenue. The risk to IBM's legacy business far outweighs the small gains it is making in cloud services.

IBM also continues to face major problems around the globe. Slowing growth has definitely hurt demand in emerging markets, and last year's NSA revelations have also made foreign countries somewhat hesitant to use American hardware. Global revenue dropped 4%, but there was significant divergence around the globe. Americas' revenue dropped 4%, but Europe, the Middle East, and Africa was a strong spot, up 4%. This growth was a less impressive 1%, adjusting for currency. Asia-Pacific continues to be a disaster, down 12% as IBM faces massive problems in China where hardware sales have fallen precipitously.

Revenue from IBM's self-described "growth markets" dropped 11% and were down 5% on a constant currency basis. Similarly, BRIC revenue was down 11%, 6% after adjusting for currencies. If IBM is going to start growing sales again, it needs to find a way to stop the bleeding in emerging markets. Nations like China are focused on developing domestic technology rather than importing technology from US firms. This reality poses a structural problem for IBM and many other entrenched tech firms. IBM cannot afford continued double-digit declines in growth markets.

In an order to grow EPS despite declining sales, IBM continues to aggressively repurchase its stock. The average diluted count was down by 82 million shares or 7.3% over the past twelve months. During the first quarter, IBM bought back stock at a blistering pace, spending $8.17 billion just in the quarter. The dividend also cost $990 in the quarter. Keep in mind, GAAP operating cash flow was only $3.3 billion, and first-quarter free cash flow was $631 million. As a consequence, cash on hand fell by about $1.3 billion, and total debt increased by about $4.3 billion.

Now, there are some timing issues with first quarter free cash flow, and IBM's cash flow tends to be higher in the latter half of the year, so the disparity between cash flow and capital returns will decline. Nonetheless, IBM can obviously not keep this pace of share repurchases going. I expect a pace closer to $3 billion per quarter over the rest of 2014. Still, between the dividend and buyback, IBM will be returning more cash to shareholders than the free cash flow it generates. While this effort will boost near-term earnings, it is not sustainable forever.

If IBM is to maintain or grow its capital returns, it needs to find a way to grow revenues. This quarter offered little progress on this goal. Hardware remains troubled, and software growth is tepid. IBM also continues to face major declines in emerging markets, and it needs to find a way to slow the bleeding in these critical markets. Thanks to share buybacks, IBM says it should be able to earn $18 on an operating basis this year. With no visible organic growth, overly aggressive capital returns, and problems in hardware and Asia, IBM should trade at a significant discount to the market.

Now, IBM should generate about $15 billion in free cash flow in 2014. I would only be interested in buying IBM if there was a free cash flow yield of 8%-8.5% to provide some protection against potential free cash flow erosion. At that yield, IBM would be trading between $165 and $175. 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%-15% downside to fair value. After this quarter, I would be a seller of IBM.

Source: Lacking Growth, IBM Is A Sell