IBM: A Decent Q1 But Worse-Than-Expected Outlook

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 |  About: International Business Machines Corporation (IBM)
by: Bottom Up Investing

Summary

The first quarter was decent when measured in constant currency.

The slump in hardware sales could continue through 2014, but the 2015 comps will be easier to beat.

The technicals are bullish and the intrinsic value estimate is $180 per share.

International Business Machines (NYSE:IBM), the technology behemoth, reported a first quarter that on the surface appeared horrible, but upon further review, in constant currency the quarter was decent. But hardware sales slumped, as IBM lost market share in the industry.

The most concerning part of the quarter is that management didn't sound optimistic about the near-term future of the hardware business. Consequently, I lowered my intrinsic value estimate from $230 per share to $180 per share. Additionally, I think the profitability margins may come in lower than I expected, but slightly up from last year.

I'm still bullish on the company, and I think the play is still "buy-on-dip." But I don't expect IBM to outperform the market on a buy-and-hold basis.

Recent Developments

  1. IBM is partnering with more than 1,000 universities across the globe to develop curriculum that reflects the mix of business, technical and problem-solving skills that are necessary to prepare students for Big Data and Analytics careers.
  2. IBM inventors patented a cloud computing invention that enables the dynamic prioritization of data in the cloud.
  3. IBM entered into a definitive agreement to acquire Silverpop, which empowers marketers with cloud-based capabilities that deliver personalized customer engagements in highly scalable environments and will accelerate IBM's leadership in marketing automation.
  4. According to Gartner, IBM is the market share leader in application infrastructure and middleware software, which is the 13th consecutive year.
  5. IBM introduced new software and services aimed at addressing the $3.5 trillion lost each year to fraud and financial crimes.

Analyst's Note

International Business Machines Corp is an information technology company. It creates business value for clients and solves business problems through integrated solutions that leverage information technology and knowledge of business processes.

Revenues for the first quarter came in 3.9% below the prior year's quarter. The decline is in line with my view for the full year, as I am expecting a revenue decline of 3%. It seems that I am forecasting too much gross margin expansion for the full year, as my forecast is for 52% and Q1 came in at 47%. I continue to expect margin expansion on the product mix shift and divestitures. The operating margin was definitely disappointing; I'm forecasting 23% for the full year and the first quarter came in at about 14%. But a one-time, workforce rebalancing charge that will reverse over the course of the year adversely impacted Q1. Without the charge, the operating margin was close to 18%. Again, I think margins will expand on the product mix shift and divestitures. But I may revise my full-year forecast slightly lower to account for the disappointing results.

For the year ending (in millions of dollars except per share data):

2012-12

2013-12

2014-12E

Revenue

104507

99751

97000

Gross profit

50138

48505

50440

Operating income

20443

18777

22310

Net income

16604

16483

18003

Diluted EPS

14.37

14.94

17.00

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As you can see, the model incorporates a substantial amount of margin expansion from the mix shift to higher value. While the timing may be incorrect, the vector is likely correct. Consequently, I may scale back my expectations for this year after more information is disclosed.

2011-12

2012-12

2013-12

2014-12E

2015-12E

Asset turnover

0.92

0.88

0.79

0.77

0.75

Financial leverage

5.78

6.32

5.50

5.50

5.50

Debt-to-capital

0.61

0.64

0.63

0.63

0.64

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Assets should continue to grow faster than sales as the former is forecasted to decline. The liquidity is ample and the solvency position appears solid. I'm not expecting much of a change in the capital structure. The reason for that assumption is because the company is undergoing a substantial amount of operating changes, and changes in the capital structure aren't anticipated until the business changes are completed.

For the year ending (in millions of dollars):

2011-12

2012-12

2013-12

2014-12E

2015-12E

Cash flow from operations

19846

19586

17485

18430

17877

Capex

4108

4082

3623

3400

3300

FCFF

16077

15883

14194

15362

14909

FCFE

16787

18197

20202

15030

14577

Share repurchases

15046

11995

13859

16000

16000

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Cash flows from operations are expected to almost mirror sales with the exception of 2014 when working capital requirements are lower than the prior year. I think capital expenditure continues to decline as the company shifts its product offerings. Cash flow to the firm is expected to fall just below management's objective of $16B. Lastly, net income is forecasted to be returned to shareholders in the forms of dividends and share repurchases.

First, management seemed less confident about the future of the hardware business during the Q1 CC than they did during the Q4 CC. That, to me, is a good sign. There are several forces at play in the hardware industry and few of them are good; generally, a large portion of the hardware industry is commoditized. Besides that, IBM should continue to generate strong returns on equity. But longer term, I worry about the health of the services businesses, as the competitive environment could weigh on the results of operations.

General Risks

  1. The share price is likely to remain volatile, and investors could lose a portion or all of their investment.
  2. Investors should judge the suitability of an investment in IBM in light of their own unique circumstances.
  3. A decline in the global economic growth rate and/or a decline in the pace of economic growth in the United States could adversely impact the results of operations and the share price.
  4. The technology industry is characterized by rapid technological change, which could materially adversely impact the results of operations.
  5. Competition in product development and pricing could adversely impact performance.
  6. Incorrect forecasts of customer demand could adversely impact the results of operations.
  7. Higher interest rates may reduce demand for IBM's offerings and negatively impact the results of operations and the share price.

This section does not discuss all risks related to an investment in IBM.

Portfolio & Valuation

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The technical play remains buy-on-dips. IBM is in a bull market of intermediate degree and a bear market of primary degree. Consequently, this could be an excellent time to catch a ride on what could be a substantial move higher.

Monthly expected return

Quarterly expected return

Quarterly standard deviation of returns

1.04%

4.09%

7.60%

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Intrinsic value estimates

Forward multiplier valuations based on base case intrinsic value

Optimistic

$215

P/E: 10.60

Base case

$180

P/S: 1.97

Pessimistic

$145.50

P/BV: 8.33

P/CFO: 10.35

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Given, the results of the first quarter, I'm reducing my intrinsic value estimate to $180 per share from $230 per share. I expect the hardware sales slump to be protracted. Further, management is divesting the System X business, which was a relative outperformer during the quarter. Lastly, weak sales in emerging markets could continue through the rest of 2014. Thus, the combination of business fundamentals has lead to IBM being valued below its 5-years average valuations.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.