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Summary

  • Quality of earnings and lower cash-flow a big concern.
  • Estimate revisions for '14 and '15 still forecasting low-single-digit revenue growth.
  • The quality of IBM's 2015 EPS goal of $20 per share is being questioned.

IBM (NYSE:IBM) is scheduled to report their Q2 '14 earnings after the close tonight, with Thomson Reuters analyst consensus expecting $4.29 in earnings per share (EPS) on $24.12 billion in revenues for expected year-over-year (y/y) growth of 10% and -5% respectively.

Q2 '14 analyst consensus has slid from $4.39 in EPS at the conclusion of Q1 '14 financial results to the $4.29 today, while expected Q2 '14 revenue has remained flat.

IBM has missed revenue consensus the last 5 quarters in a row from between 2% to 5% and 7 of the last 8 quarters.

IBM revenue growth has been negative in terms of y/y growth for 7 of the last 8 quarters.

For full-year 2014 and 2015, current consensus is expecting $97.4 and $98.3 billion in revenue for growth of -2% and 1%, and $17.87 and $19.78 in EPS for expected growth of 5% and 11%.

In Q1 '14, IBM hit the EPS estimate mainly from what are thought to be "below-the-line" items like the lower tax rate, share count, etc. which speaks to the quality of earnings. The Services backlog fell 2% while Emerging Markets and the Hardware business continue to be a drag.

Gross margin (GM) has averaged 47% over the last 5 years. Anytime the GM has hit 52% it has slid lower over the last 5 years.

IBM (NYSE:IBM)

EPS Consensus Trends

Revenue Consensus Trends

2014

2015

y/y gro

2016

y/y gro

2014

2015

y/y gro

fy '16

n/a

est

est

2014 rev

2015 rev

est

2016

current (7/17/14)

$17.87

$19.78

11%

$21.56

9%

$97,384

$98,328

1%

$101,186

3%

Jun '14

$17.87

$19.80

11%

$21.47

8%

$97,379

$98,323

1%

$100,856

3%

May '14

$17.89

$19.81

11%

$21.51

9%

$97,397

$98,393

1%

$101,033

3%

Apr '14

$17.89

$19.81

11%

$21.51

9%

$97,465

$98,583

1%

$101,033

2%

Jan '14

$17.86

$19.88

11%

$21.62

9%

$99,439

$100,770

1%

$103,014

2%

Oct '13

$18.03

$19.86

10%

no est

$101,326

$103,696

2%

$109,565

6%

Jul '13

$18.38

$20.11

9%

$22.31

11%

$104,690

$107,305

2%

$115,963

8%

Apr '13

$18.35

$20.23

10%

$21.76

8%

$106,135

$109,760

3%

$116,033

6%

Jan '13

$18.45

$19.85

8%

$20.95

6%

$108,976

$111,219

2%

$113,997

2%

Dec '12

$18.42

$18.56

1%

$20.18

9%

$110,164

$111,913

2%

$115,200

3%

# of ests

24

24

9

22

24

8

* Source: ThomsonReuters current and historical consensus estimates

* IBM reports on a calendar year

* Source Reuters Estimate detail and internal spreadsheet

The biggest source of concern for IBM, is the steadily declining growth rate of forward estimates, which is pressuring their income statement and cash-flow.

In Q1 '14 per one source, IBM's lower effective tax rate guidance amounted to an increase of $0.60 in EPS for 2014, which is roughly a 3% boost to the current 2014 consensus of $17.87.

In terms of IBM's valuation, Big Blue is trading at 11(x) and 10(x) the consensus 2014 and 2015 EPS estimates of $17.87 and $19.78, with expected growth of 5% and 11%.

No question, 2015 is looking a little better in terms of expected EPS growth (see table) even as revenue has dropped into the expected low-single-digit growth range.

What is worrisome:

Here is our cash-flow analysis of IBM, which is a bit worrisome, particularly the cash-flow coverage of net income:

IBM Cash-flow analysis12/31/20149/30/20146/30/20143/31/201412/31/20139/30/20136/30/20133/31/201312/31/20129/30/20126/30/20123/31/201212/31/20109/30/20116/30/20103/31/201112/31/20109/30/20106/30/2010
4q trailing net incomen/an/an/a$16,091$16,828$16,477$16,592$17,247$16,936$16,593$16,276$16,059$15,856$15,623$15,373$14,095$11,232$10,788$10,413
4q trail Op cash flow cvg net incn/an/an/a92%93%125%130%128%133%133%137%135%130%112%114%123%174%166%179%

4q trail FCF cvg of net inc

n/an/an/a62%65%97%101%104%107%106%110%110%105%85%87%95%141%134%147%
4q trailing CFOn/an/an/a$14,796$15,703$20,636$21,544$22,051$22,493$22,020$22,304$21,675$20,664$17,436$17,516$17,304$19,549$17,946$18,588
4q trailing CFO - growth raten/an/an/a-33%-30%-6%-3%2%9%26%27%25%6%-3%-6%-12%-6%-12%-6%
4q trailing FCFn/an/an/a$9,904$10,969$15,921$16,824$18,017$18,186$17,635$17,974$17,671$16,604$13,332$13,396$13,343$15,853$14,491$15,278
4q trailing FCF - growth raten/an/an/a-45%-40%-10%-6%2%10%32%34%32%5%-8%-12%-18%-8%-13%-4%
4q trailing capexn/an/an/a$4,892$4,734$4,715$4,720$4,034$4,307$4,385$4,330$4,004$4,060$4,104$4,120$3,961$3,696$3,455$3,310
y/y growthn/an/an/a21%10%8%9%1%6%7%5%1%10%19%24%17%7%-5%-13%
capex as % of revenuesn/an/an/a5%5%5%5%4%4%4%4%4%4%4%4%4%4%4%3%
capex as % of cash-flown/an/an/a33%30%23%22%18%19%20%19%18%20%24%24%23%19%19%18%
Free-cash as % of market capn/an/an/a5%6%8%8%9%8%8%8%7%7%6%6%7%9%8%9%

* Source: internal spreadsheet

If readers would scan quickly across the 2nd line in the spreadsheet, this calculation divides 4-quarter trailing cash-flow by 4-quarter trailing net income, and you can quickly see the dwindling operating cash-flow coverage of net income.

This doesn't portend anything disastrous for IBM, but like the lower tax rate for 2014, it speaks to the quality of EPS and IBM perhaps needing to stretch the sidelines to meet the "$20 in EPS in 2015" objective.

A beat on revenues and better revenue guidance for 2014 tonight, as well as a healthy quarter of operating cash-flow generation would be a welcome sign for IBM.

The trends in consensus analyst EPS and revenue estimates does seem to indicate that IBM is trapped in transition state, from which we don't yet know the end result.

The Apple (NASDAQ:AAPL) partnership is important, if it can reduce IBM's capex which you will note on the above cash-flow analysis, is now 33% of operating cash flow.

Our internal model puts an intrinsic value estimate on IBM of near $225, while Morningstar's intrinsic value estimate is roughly $210 - $212 so in the low $190's where IBM is trading today, the stock is at a modest high single-digit, low double-digit percentage discount to estimated intrinsic value.

We hold a modest 1.6% position in IBM for clients, after trimming the stock in April, 2013.

IBM has a history of making successful transitions after the mainframe debacle of the early 1990's. Is the Apple partnership the right step? Is the Cloud?

Technically we would buy a breakout above the all-time high peak of $215 - $216 from April, 2013.

The internal cash-flow metrics leave me a little worried. I'd rather be patient and wait to see some improvement, rather than add to the position at the current levels.

Sometimes the most intellectually honest action you can take is to sit on your hands, not adjust the position, and see what the quarter holds, and what management says about 2014 guidance.

IBM needs a strong operational quarter, with good cash-flow and solid earnings quality, to assuage the worry-warts.

Source: IBM Earnings Preview: Low Expectations, Revenue Revisions Negative, Stock Modestly Undervalued