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Summary

  • IBM posts second quarter results in line with expectations.
  • Sales fall for the 9th quarter in a row, despite ¨huge¨ investments into the cloud & big data.
  • Shareholders have seen huge buybacks which have fueled EPS, investors have discounted these earnings amidst the build up in leverage and sliding sales.
  • There is value in the shares as long as the focus on the new growth areas can offset revenue declines at the legacy businesses.

International Business Machines (NYSE:IBM) reported its second quarter results on Thursday after the market close. The report, which by the way looks like it has been written on a traditional typewriter, could not create enthusiasm from investors.

What is very clear is that IBM is making a huge shift in capital allocation by severely limiting share repurchases going forwards, while more funds appear to be used for improving the balance sheet and its operations. This shift in focus is to be applauded in my eyes, as potential growth prospects could drive up the valuation multiples.

Second Quarter Highlights

IBM posted second quarter sales of $24.36 billion which is down 2.2% compared to last year. Despite the drop in sales, revenues came in ahead of consensus estimates at $24.1 billion.

Despite the shortfall in revenues, IBM managed to boost net earnings by 28.2% to $4.14 billion, for incredible net after-tax margins of 17.0%.

The company has repurchased nearly 10% of its share base over the past year, reducing the diluted share count to just below the billion mark. GAAP earnings rose by 41.6% to $4.12 per share on a diluted basis as a result.

Non-GAAP earnings rose to $4.32 per share, beating consensus estimates by three pennies.

Looking Into The Numbers

Despite the shortfall in revenues, IBM managed to boost gross margins by about 40 basis points to 49.1% of sales. Yet the real margin achievements were made in the operating cost structure.

The company has cut selling, general & administrative costs by 16.1% in a very aggressive move. Costs now come down to 23.0% of sales, down 380 basis points compared to last year. Perhaps disappointing to some, the company cut its R&D budget by 20 basis points to 6.0% of sales.

These cost cuts and a 210 basis points drop in the effective tax rate which came in at 20.0% of operating income drove earnings growth.

Within the company's business segments, the software unit was the only positive surprise, posting a 1% increase in sales towards $6.49 billion. This is a very important business of course for IBM given the gross margins of 88.8%. Yet a 1% growth rate in this industry is not very appealing, with analysts looking for 3% growth for the segment. CFO Martin Schroeter issued some comforting words regarding the outlook of the software business, anticipating mid-single digit revenue growth in the second half of the year.

The company's largest Global Technology Service business posted a 1.3% drop in sales towards $9.41 billion while margins were up 60 basis points to 38.4% of sales.

Busines Services sales were down by 1.6% to $4.53 billion as margins were down by 120 basis points to 30.0% of sales. The big weakness was seen at Systems and Technology segment in which sales dropped by 11.4% to $3.33 billion, while margins fell by 280 basis points to 33.9% of sales.

Valuation

At the end of the quarter, IBM held $9.7 billion in cash, equivalents and marketable securities. Total debt stands at $46.5 billion, resulting in a heavy $37 billion debt load.

On a trailing basis, the company has now posted sales of $98 billion on which it earned $16.7 billion.

Around $192 per share, equity in the business is valued at little over a $190 billion as the float has been reduced to less than a billion shares. This values equity at nearly 2 times annual sales and just 11-12 times earnings.

It should be noted that many ¨old-fashioned¨ technology companies have traded at low multiples as well, including the likes of Intel (NASDAQ:INTC), Cisco Systems (NASDAQ:CSCO) and Hewlett-Packard (NYSE:HPQ). Yet they have all seen improvements recently, but tend to operate with stronger balance sheets as well.

Recent Investor Update

Back in June, IBM held a big investor presentation outlining a lot of interesting trends, strategic views and comments on its strategy.

Key for the future according to IBM is the theme of big data surrounded by sub-themes like mobile, cloud, social and analytics. This is as by 2017 there are an anticipated 1 trillion in connected devices and objects generating data, which is often of an unstructured nature. Notably in terms of services and software will this shift create large growth opportunities for companies including IBM.

IBM stresses that between 2010 and 2013, it has grown its analytics revenues from $11 billion towards $16 billion, being on track to rake in $20 billion by 2015. To achieve this, the company spend $7 billion on internal investments and another $17 billion to acquire 30 businesses. A prime example in all these developments is of course the Watson computer which focuses on dynamic learning.

To access and create all this big data, companies are moving towards the cloud. While IBM estimates that roughly half of the cloud applications will be in private hands, other forms like SaaS and IaaS are expected to grow rapidly as well. Most likely is however the hybrid cloud which consists out of both private (on-premise) and public cloud solutions. Cloud revenues came in at $4.4 billion in 2013, and are expected to increase towards $7 billion by 2015.

Notably the areas of cloud and big data are the areas in which IBM sees massive growth and in which it has made huge investments. A total of 119 acquisitions were made for $34 billion over the past decade, focused on these areas in particular. At the same time the firm has exited operations like printers and personal computers, which once were considered core areas, in its quest to continuously reinvent the business.

All of this has resulted in a merely 1% compounded annual growth rate in revenues which rose from roughly $90 billion to $100 billion over the past decade. At the same time operating income has tripled as the shift has been focused on higher margin businesses. Gross margins have risen from 36.5% in 2003 to 49.7% in 2013, having risen in every single year.

Final Takeaway

IBM has seriously lagged in terms of topline revenue growth over the past few years, yet the company has made huge operating margin improvements which allowed the firm to double net earnings despite flattish sales growth. Earnings per share have grown of course even quicker, as IBM has retired roughly 40% of its shares over the past decade, resulting in earnings per share explosion.

Yet shares have only roughly doubled over this time frame, as the valuation multiples have come down. Investors are apparently worried about the lack of sales growth, recent sale declines, emergence of new competitors and business models.

Especially after shares hit highs of $200 in 2012, shares have been stagnant, largely trading in a $180-$210 trading range. This is despite the continued share repurchases, which have drawn a lot of criticism amidst stagnating operating performance and a build up in debt.

The company has aggressively cut back its pace of share repurchases in recent times. After spending $8.2 billion in share repurchases, IBM announced that it will only spend $5.8 billion in share repurchases in the second, third and fourth quarter combined. This means that the company only aims to spend $2.1 billion in the second half of the year.

This means that while repurchases are expected to nearly halt, it frees up a lot of cash to ¨repair¨ or strengthen the balance sheet while it also has greater resources to invest in the business. As such I am actually applauding this very first step of cutting back the unsustainable pace of share repurchases and moving away from ¨engineered¨ EPS targets. This is to be followed by a stabilization of revenues and continued investments in new initiatives.

The resulting improved growth prospects following could inspire investors to think about IBM as a growth company again, and the recent partnership with Apple (NASDAQ:AAPL) is a big first step for the future. As such I am actually slightly optimistic on the growth prospects.

The low valuation creates a margin of safety, while overall margins remain very healthy as well. Some negative points are of course the continued slump in sales as well as deteriorating balance sheet. As such shares remain a trade-off. The core franchise of IBM and emerging growth businesses are of course very valuable which offers safety for investors, as an improvement in sales could again lead in multiple expansion, creating much more and quicker value than sizable repurchases can do at the moment.

I remain cautiously optimistic thanks to the apparent change in capital allocation.

Source: IBM - Shifting Focus From Repurchases To Operational Improvements Is To Be Applauded