Why This Bear On IBM Is Moving Toward A Bullish Posture

| About: International Business (IBM)


IBM stock has become controversial, with the bears getting aggressive and going against lots of fervent supporters of the shares.

IBM shares have massively underperformed the market over the past two years, and their time may be coming.

Yet, the fundamentals suggest the stock could well be overvalued and that IBM could lead a fresh bear market to the downside, if the current bull market gives way.

Because of IBM's worsening underperformance plus fundamental factors, I have moderated my bearishness on IBM, and I'm now looking and hoping for a reason to go long this name.

Background: It is in the nature of strong bull markets that market leaders become laggards for fundamental reasons, then play catch-up due to P/E expansion. If corporate fundamentals then turn, the bears look silly and the faithful say they knew it all along. A prominent name that might be getting ready to play that role is International Business Machines (NYSE:IBM). Maybe.

One of several reasons is contarianism. A well-known tech stock analyst, Fred Hickey, has joined a very non-prominent commentator (me) in bearishness on IBM as a participant in the recently-published Barron's mid-year Roundtable. Mr. Hickey took his bearishness to such a level that he announced he was short IBM. I commented on this in a recent InstaBlog.

Not long before that, I wrote an article in Seeking Alpha, pointing out that a former media fan of IBM, Bloomberg News, was now running overtly negative articles about it. In that article, I advanced my bearishness a notch, raising the question of whether IBM was not only a "don't buy" but was an outright sell. (Previously, such as in my first Seeking Alpha article on IBM, in which I criticized Bloomberg for slanting the news in IBM's favor, I had simply suggested that new money was better off going into other names.)

Now, I wonder if this bearishness is overdone, especially in view of the strength of the overall market. The continuing erosion of IBM's share price, currently just under $181/share, along with some newer developments, combine to make me revisit IBM, this time with a more hopeful eye. There are only so many large-cap vehicles with which to try to make money, and IBM may finally have gotten too cheap relative to a rich market to drop much more without substantial cause, as is discussed below.

While the bear case relative to the overall market is weakening, an important caveat relates to a string of elevated valuation parameters for the market. On their own merits, normalized for an "average" market, IBM shares are not at compelling valuations. We do not, however, get to choose which times to invest in, so IBM's relative undervaluation by a number of criteria have finally gotten extreme enough that my bearishness on it relative to the market as a whole is wilting.

This article lays out a case for neutrality toward IBM, in which the negatives I and others have laid out in the linked articles above, including Mr. Hickey's points, should be understood, but where they begin to look increasingly discounted by IBM's continually lagging share price.

Introduction: IBM has copious free cash flow. At current prices around $181 per share, the stock is selling at little more than 10X free cash flow, or close to a 10% implicit cash yield to shareholders.

The most recent Value Line report on IBM shows it covering its interest charges by 20X, so even though its long-term debt is close to $40 B, it is easily covering the annual cost of that debt. While annual corporate sales have gone more or less nowhere for the past decade, operating margin and net profit margin have risen smartly. Thus, IBM can point to certain positives in its performance, even though it has taken over $20 B, worsening its net cash position to return all the money it has returned to shareholders.

IBM has four main business lines, though it divides its services segment into two. Services grouped together account for more than half its revenues, but has intrinsically low margins. A second business line is the Hardware segment, which includes both powerful computers and semiconductors. A third is Software, and the smallest part of the company by revenue is its Finance segment. Later, I will briefly discuss whether IBM may begin considering splitting itself into constituent parts.

The evolving case for IBM stock: There are several threads that could come together to push IBM stock up, including to new highs. One is the fact of IBM's underperformance relative to the averages. Here's a two-year chart of IBM versus the S&P 500:

This is a truly extraordinary period of underperformance.

The second point is that while IBM's operations have foundered, they have not collapsed. Hiring decisions that assumed that the company would grow have been reversed. The embarrassing repeated charges for large-scale firings of employees have done the company's image no good. As always, though, the bullish question remains as to whether IBM is now lean and ready to grow with stronger margins.

A third point is that the stock is cheap by today's standards, assuming that profits start growing again, at least to some degree. Outside of insurers or other undifferentiated financial companies, how many high-quality names are selling at FCF yields around 10%? Few, if any.

A fourth point is that IBM may be getting more serious about generating future economic profits, rather than focusing excessively (my view) on financial engineering. Rumors recently went mainstream that IBM is shopping its loss-making semiconductor division for sale. If it sells that, not only will its remaining hardware sales be further shrunken, but it will then have free rein to make a further substantial cut in R&D. By jettisoning semis, IBM can increase its profitability substantially. Whether it would then be interested in selling its mainframe division, and would be able to find a buyer willing to take it off its hands, is interesting further speculation.

A fifth point is that the underlying case for IBM turns on the inexorable digitalization of the world. IBM has numerous opportunities to grow, and has the operational and financial ability to do so again.

The above is not comprehensive, and shows that there are good reasons to believe that IBM may be basing and headed up.

Technical position: IBM may have made a triple bottom around $173 between last October and this February. A triple bottom is a potentially durable formation. On the other hand, the recent breakdown in various moving averages also makes for a decent bearish technical argument. Given the prolonged nature of this bull market, which has barely been interrupted since H2 of 2011, investors are reasonably wary of a new bear formation appearing out of nowhere. Technically chancy stocks such as IBM can be just the ones to chew up the bulls who were betting that the bullish rotation into the bargain stocks will continue just as a bear market appears out of nowhere.

Since I don't ultimately pay all that much attention to technical patterns, I'll leave this section with the above remarks and state that IBM has both bullish and bearish chart patterns.

Valuing IBM on a sum-of-the-parts basis: If IBM still had, or can reconstitute, a robust hardware segment along with its solid software business, the synergies between the consulting arm(s) of IBM and the rest of the business argue for continuation of the current integrated business model. It may be interesting, though, to think of whether the loss of the poorly-performing hardware division would then allow enough synergies to make continuation of IBM as one company in the best interests of shareholders. IBM could become three dominant companies, initially allied with each other. In services/consulting, it could be a great, focused competitor to Accenture (NYSE:ACN) and others. In software, it could be one or even two companies. As far as financial services go, whether that division would be a standalone company or be shopped to another entity wanting to enter the tech financing business would be determined by more knowledgeable people than I.

If shareholders are going to be better off with a small or nonexistent hardware division, management owes it to shareholders to do what Abbott Labs (NYSE:ABT) did a few years ago, and consider breaking itself into pieces: First, it spun off Hospira (NYSE:HSP), then AbbVie (NYSE:ABBV). Abbott did this out of strength, and IBM is still strong enough to adopt the same posture, if that's how the facts point. Whether this would be better for shareholders than remaining integrated is not a topic I have enough expertise in to discuss further, but I believe that all options to make Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) and all other IBM shareholders better off should be considered.

Catalysts for stock movement: I confess that I usually get this wrong. Will it be an earnings surprise or Q3 forecast that moves the stock into a breakout or breakdown posture? Will it, in fact, be a major announcement relating to the hardware segment that allows IBM to paint a persuasive upbeat picture that leads investors to give it, say, a 12X P/E on prospective $20+ EPS?

Or will IBM continue to stay in a trading range?

If the stock moves sharply in one direction or the other, there will be a catalyst. Maybe we can identify it ahead of time, but that's quite a guess. This aspect of the future is always difficult to predict.

A surprising source of much of the IBM debate: In researching this article, I found an unusual analysis of IBM by S&P Capital IQ, the stock rating arm of Standard and Poor's. In making a 12-month price prediction, this organization uses a weighted average of two metrics. In IBM's particular case, they are wildly divergent - much more so than I can remember seeing ever before. The P/E metric implies a price one year from now of $322. However, the P/E-to-growth analysis implies a target of only $142. This difference is so enormous that I think it explains a lot of the reasons there are strongly held views for and against IBM shares. IBM is too cheap to its large cap/mega cap peers on a P/E basis, but it is also overpriced when comparing its P/E to weak or negative growth. This pattern is not seen often. It makes sense that it should resolve, but again, the uncertainty is, in which direction.

Conclusion: IBM can rationally be looked at as either way too cheap or far too expensive, just as the two different S&P metrics show. Given how much Big Blue has lagged this raging bull market, the bull case for it to join the party is looking more attractive. I therefore have changed my bearish stance on IBM to one of neutrality. However, there is simply not enough evidence to persuade me to open a position in IBM.

Adding the above complexities to the iconic nature of IBM, both the corporation and its stock, one gets quite an interesting situation. I'm watching closely to see the future of what once was the stock of the future, and hoping that if it becomes an engine of growth again, I'm smart or lucky enough to jump back into this name.

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

Additional disclosure: Not investment advice. I am not an investment adviser.