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Summary

  • Rally in IBM shares from multiple bottom unjustified.
  • First quarter results expose weaknesses in most business segments.
  • Competitive pressures will mute growth prospects.

Despite dropping sharply after reporting weak quarterly results in February 2014, IBM (NYSE:IBM) shares rallied back from yearly lows. Shares rebounded from around $170, and would have headed above $200 were it not for yet another disappointing quarter. This time around, the negative momentum in its stock might accelerate, paving the way for short sellers to boost a bearish position in the company.

Few bright spots

Revenue dropped in nearly every segment of IBM's business. The units that held ground barely did so. Software revenue was up 1.6% over last year while revenue from Global Business Services did not change. In all, quarterly revenue was $22.48 billion, below consensus estimates of $22.9 billion. This is the lowest figure since Q1 2009.

Expenses up

Expenses rose by 12.8 percent compared to last year, and now account for 28 percent of revenue. IBM blamed the 2 point increase on acquisitions. Workforce rebalancing cost IBM $870 million.

IBM implies that the one-time costs will mean lower expenses ahead. R&D costs fell 8.7 percent, but the company will invest $1 billion in platform-as-a-service to connect enterprise data and applications to the cloud.

Growth expectations muted

IBM highlighted its acquisition of Aspera and Cloudant, its development around Watson, and investments in SoftLayer cloud hubs. By selling its server business to Lenovo (OTCPK:LNVGF) and its customer care services business to SYNNEX Corporation (NYSE:SNX), IBM looks like it is in a better position for growth. Yet there are problems with this outlook.

Amazon.com (NASDAQ:AMZN) dominates the public cloud market, but it, too, is facing competitive pressures. The AWS provider cut prices in March. This was in response to Google (NASDAQ:GOOG) (NASDAQ:GOOGL) cutting prices for its Google Cloud Platform by as much as 85 percent. Rackspace (NYSE:RAX) also cut prices by 33 percent for its cloud bandwidth and content delivery services.

Rackspace is best known for offering quality support for its hybrid cloud solutions. More importantly, the firm embraces OpenStack, which puts a focus on managed services. IBM's SoftLayer focuses more on infrastructure. Despite the heavy competition, IBM grew cloud revenue by over 50 percent in the last quarter.

IBM plans to spend $1.2 billion in growth businesses that includes SoftLayer.

Other risks

Cash dropped by $1.4 billion from the last quarter. IBM ended the quarter as at March 31, 2014 with $9.4 billion. IBM spent $.82 billion in share repurchases, compared to $2.6 billion last year. Debt rose from $32.9 billion last quarter to $34.7 billion. Free cash flow dropped by over $1 billion.

Optimistic outlook

IBM aims to generate $18 in operating earnings per share for the fiscal year and $20 in 2015. This outlook comes despite geographical challenges. Growth markets decelerated by 5 percent in IBM's first quarter. Revenue dropped the most in China (down 20 percent).

Hardware sales also decelerated for IBM. Sales were $2.4 billion last quarter, down 23 percent from last year.

Risks accelerating

IBM's operating earnings guidance looks too optimistic. The firm benefited from a lower tax rate in past quarters, acceleration in the buyback plan, and one-time cost cuts. The higher debt levels will constrain IBM from buying back even more shares. Slower sales from growth markets will also hurt cash flow in the quarters ahead. Since revenue growth is likely to drop, investors are better off looking at Rackspace and Google as cloud plays. In the meantime, current IBM investors will need to look for clues that revenue generation from acquisitions is accelerating.

Source: Risks Accelerating: Sell IBM