- IBM had a clean quarter, with a mild EPS beat and a sales beat.
- It reiterated and possibly slightly upgraded guidance for the second half.
- Several parts of its business may have bottomed, and the partnership with Apple may suggest new creative thinking at IBM.
- The shares now look attractive to me, though a turnaround has not happened yet.
Background: The headlines are late to notice that International Business Machines (NYSE:IBM) has had declining year-on-year sales for nine quarters, but where were these headline writers until now? Sentiment has gotten so bad on IBM that the Barron's Midyear Roundtable featured a tech expert, Fred Hickey, announcing that he was short the stock. That marked the bottom, at least for now, as I suggested in my recent article "Why This Bear On IBM Is Moving Toward A Bullish Posture."
While I am not bullish on the stock averages, I think the odds now favor relative bullishness on IBM - finally.
Introduction: IBM itself needs little introduction. How many companies have what is still probably the most famous computer in movie history allegedly named after them? As the HAL 9000 computer in 2001: A Space Odyssey notably said as it was "dying":
Look Dave, I can see you're really upset about this. I honestly think you ought to sit down calmly, take a stress pill, and think things over.
I wonder if the IBM shorts will need to start taking stress pills. It seems to me that the bad news about IBM is stale. Accelerating EPS gains would be a surprise, and - who knows? - IBM is hinting that Q4 might see such a trend begin.
IBM's Q2 and conference call: Most of you will have seen that IBM had a fairly clean quarter, with $4.32 EPS and no workforce rebalancing (layoff) charges. I have criticized those cash severance charges as being operational and not being worthy of being treated specially, but I go along with non-GAAP, operating earnings for Q2. That's because the major difference between GAAP and non-GAAP this quarter were related to non-cash charges for amortization of goodwill and intangibles. Both sales and EPS beat consensus by a bit. Various parts of the business and geographical regions are said by management to be bottoming, including China and other "growth" regions, as well as software and (it is hoped) the dominant services segment. Progress in the still-small Cloud division was noted; the new partnership with Apple (NASDAQ:AAPL) was highlighted.
I was satisfied with the tone in this release and conference call. I had felt that IBM was trying, unsuccessfully, for a while to hide its troubles. This belief led me to write my first article about IBM a year ago, following weak Q2 results, "IBM And The Media Attempt To Obscure Its Declining Business Results."
It may now be hoped that IBM has recognized that with the spate of bad publicity it has recently received, not only in that Barron's Midyear Roundtable piece but in the recent Bloomberg Business Week article that showed a rain cloud pouring down on CEO Ginni Rometty, it's time to admit that IBM faces major challenges. (Could that Business Week article, titled "The Trouble With IBM," could be to IBM similar to its "The Death of Equities" cover from 1979 - briefly accurate, but ultimately wrong?)
Guidance: At the end of the conference call, IBM offered comments about the second half of this year:
In the second half, we see, as I noted on an earlier question, we see our Software revenue growth accelerating to mid-single digit. And we see our Services profit growth of mid-single digit, driven by productivity in the base. And then on STG, as I just noted, we see that profit stabilization still. So when I think about the second half and how that plays out, as we did 90 days ago, I said that I think EPS in the second half will be a little bit faster in the fourth than in the third.
So kind of a double-digit fourth quarter EPS and a single-digit third quarter EPS. And bear in mind, that that single-digit EPS growth even in the third because of seasonality kind of translates to no more absolute EPS than what we get in the second. So we still see that same mix skewed toward the fourth quarter, when we have the benefit of very strong Software performance, when the productivity hits and helps our margins and services and we get that transactional benefit from STG.
IBM specifically guided to at least $18 in operating EPS this year and at least $20 in operating EPS next year. It said that it is going to do at least $16 B in free cash flow this year if it is going to meet its $18 EPS target.
Management did not guide as to whether it is indeed shopping its semiconductor production division, but it reaffirmed its R&D commitment to find ways to go beyond silicon to drive semiconductor technology to go smaller than the 7 nm node limitation that is of concern within the industry. (There was a major IBM press release on this a few days ago.)
Let's go back to the Q3-4 guidance. IBM appears to be talking about a double-digit percentage EPS gain yoy in Q4, with Q3 similar to Q2. In last year's fourth quarter, GAAP EPS were $5.73 and operating (non-GAAP) earnings were $6.13. Since IBM keeps talking about operating earnings, I'm going to assume that the comparator for this year is $6.13. The lowest-possible double digit EPS gain is 10% of $6.13, or 61 cents. That would take Q4 to at least $6.74, which is a small beat to the listed pre-earnings consensus of $6.64. But a low double-digit EPS gain is more likely to be higher than 10%, because IBM would not talk about beating by a double-digit percentage if it was just thinking one point above 9% (single digits).
Now, did IBM guide down for Q3? Consensus at $4.44 is slightly above Q2's $4.32, but IBM may have guided to flat yoy, not up a few percent, as $4.44 would imply.
When I put something like a 12% yoy EPS gain for Q4 together with flat earnings for Q3, I do get to IBM's predicted "at least" $18 for this year. This is slightly ahead of current published consensus for $17.87 EPS for this year. Not a biggie, but the stock is cheap compared to its peers on a P/E basis.
Valuation: Valuing IBM is a conundrum. S&P Capital IQ, using a proprietary method, gives a fair value of IBM shares of $262. It has a sort of schizoid $200 price target. On the one hand, a comparative P/E analysis to its S&P 1500 Information Technology Sector gives a (12-month) price target for IBM of $322 per share. However, its P/E to growth analysis gives a price target of only $142. Weighting those two gets them to a $200 price target.
This unusually large dichotomy between two major methods of valuing equities may well explain the widely different views between IBM bulls and bears.
IBM is trading right around 12X current year free cash flow, which is an 8.3% FCF yield. Even though some of this may be goosed a bit by new debt, most of that is real operating FCF not due to financial engineering. That's attractive to me, given the very low yields available up and down the yield curve for all classes of borrowers.
Apple, and a milestone: As we know, IBM announced this week that Apple and IBM have already been working together to develop apps and other products and technologies that IBM's small army of over 100,000 salespeople will promote. Of course, Apple's CEO, Tim Cook is a former IBM executive and was recruited by Steve Jobs to Apple from IBM. This looks to me like a positive for IBM, as well as a major positive for Apple. Apple makes the highest-quality tablets and cellphones with the most coherent mobile operating system. IBM reps need to spend no time explaining what Apple and iDevices are about to its clients; it can get right into the selling proposition. This can only help IBM at the expense of competitors such as Accenture (NYSE:ACN).
I see the IBM-Apple partnership as reflecting some welcome innovative thinking at IBM. The value of this partnership may exceed its P&L value.
The milestone that IBM highlighted is that its share count has been brought below one billion, from over two billion. IBM was in the vanguard years ago in shrinking its share count.
IBM's future: IBM is so huge that it's hard to get a full grasp of its operations. Its gigantic consulting/services operation is a slow-moving behemoth. Services benefit from dynamism in the rest of IBM - hardware, software and also financial services. So IBM must try keep up with the Joneses in as many segments as possible - I would argue that share buybacks should be sacrificed to the degree necessary to grow the overall business.
This need to grow and show leadership may be why it put out a press release about its research into the future of semiconductors; it knows that it must keep up with the very tough competition, and rather than staying quiet about it for competitive reasons, it wants us to know this.
Warren Buffett famously stayed out of the tech boom of the '90s, saying he did not love owning businesses that were subject to unpredictable changes in technology paradigms (that's a paraphrase). Yet, also famously, he much later made IBM a top-five Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) investment. I believe he did this thinking that IBM is so well-known, so iconic, so diverse, and so technologically endowed in the great non-medical growth industry of our era that it makes sense for him to hitch his wagon to it. There are many arrows in IBM's quiver; Sam Palmisano is a solid chairman of the board, and Ms. Rometty deserves time to show that she can lead IBM toward stronger results. The case that IBM should be the exception that proves the older Buffett tech stock rule is a reasonable one - but it remains to be fully validated.
IBM remains very much a work in progress, but I see hints that this somewhat awkward battleship is turning the metaphorical corner.
Risks: IBM is beset with challenges. There is no special "right" that IBM has earned, by virtue of its fame and size, to have high and rising operating margins. Every year that passes is a year from its glory years. MBAs graduating now couldn't care less about IBM's storied past. For them, Apple's an old company and youngsters such as Facebook (NASDAQ:FB) may be a little boring as well.
As a mega-player, IBM is sensitive to macroeconomic issues. The global economy has not demonstrated that it can function well without substantial money-printing out of governments and their captive central banks. IBM has issues with the real economy, as well as with the old corporate fallback of inflationary sales and profits gains, with deflation still not off the table.
My view is that IBM is riskier than many people think it is. This is not an electric utility with a local monopoly.
Conclusion: I do not like to argue with yoy profits increases to record second-quarter levels, where the stock has lagged and is well off its highs both in price and in time. Also, I like to buy into a large cap-megacap stock where at least meaningful segments of informed opinion have turned as publicly negative as I have documented they have become on a company.
It is not simple or necessarily correct, but it is easy to look at IBM at its $190-ish current trading level and be able to look forward a year or two and wonder why it could not trade at a very unchallenging 12X that $20 operating EPS that it projects for 2015. And once it achieves 12X, why not 14X?
Given that IBM's dividend yield is about equal to the yield on a 10-year Treasury note, any price gains will be welcome.
I have initiated a starter position in IBM near the open today with the hope that it is going to use its immense resources to engineer an operational turnaround that will give Mr. Buffett yet one more reason to be called an oracle.