IBM (NYSE:IBM) has been a leading company in the tech industry for over one hundred years. Through bold leadership and innovation, the company has moved from milestone to milestone creating some of the most important inventions of the twentieth century, and winning a few Noble Prizes along the way. In this millennium IBM has continued to be dominant in many areas and is still a massive and successful organization. However, revenue has been falling for years now and many new competitors, technologies and international issues are emerging which threaten IBM. Founder Thomas Watson famously said: "All the world's problems could easily be solved if people were only willing to think." Well now in the modern tech industry it is IBM which has to think and evolve to maintain its position in the computing world.
Forward looking Innovation
Earlier this month, IBM announced it had created a computer chip (called TrueNorth) which can processes huge amounts of information and works in a "brain like" fashion. It is a massive step forward for computer chip technology and has the potential to vastly increase the power and capabilities of computers. At the same time IBM said that it will be pouring $3 billion into chip technology R&D, which could lead to further breakthroughs that could revolutionize computing. In addition to this new type of computer chip IBM has continued to develop its artificial intelligence computer "Watson" and since winning the game show "Jeopardy" it has been used in many other areas including management and healthcare. It was this kind of forward looking innovation that made IBM what it is and it is a positive sign that it is continuing to create amazing new technologies.
More practically, IBM has continued to shift its focus to the booming industry of cloud computing. Although IBM is well behind competitors like Microsoft (NASDAQ:MSFT) and Amazon (NASDAQ:AMZN), it is beginning to catch up with sales growth of cloud services at 86% for the second quarter (compared with 45% for the industry) and annual sales are expected to top $6 billion for the first time this year. This being one of the few segments in which IBM is seeing impressive sales growth, it is aggressively developing, improving and expanding its cloud computing services. IBM recently bought two high-end cloud security service companies in order to improve its own cloud security systems. This is another way in which IBM is advancing its technological capabilities and it is a very positive move because of the popularity and advantages cloud computing offers IBM's customers.
Well Priced Stock
Despite the problems IBM is currently facing (discussed below) there are several key factors that make this stock a very attractive one. First off, the P/E ratio is at just 12.1 which means the stock is cheap allowing room for growth. Apple (NASDAQ:AAPL) and Microsoft each have P/E ratios of 16.9, or 40% higher than IBM. IBM has also increased EPS share using a mix of cost cutting and stock buybacks to increase EPS 42% q-o-q, from $2.91 per share in Q2 2013 to $4.12 per share in Q2 2014. Last but not least, the company pays a good dividend rate of 4.40 and has a yield of 2.30%.
IBM data by YCharts
Despite the good ratios and earnings, it still has many worrying financial and sales related issues. This quarter has seen:
- Net income of $4.14 billion on sales $24.36 billion which represents a 28% increase in profit and a 2.25% decrease in sales relative to Q2 2013.
- Net cash flow from operations increased to $3.9 billion, up from $3.6 billion in Q2 2013. However, for the total first half of the year net cash flow has decreased from $6 billion in H1 2013 to $5.4 billion in H1 2014.
- From Q2 2013 to Q2 2014, $1.01 billion of cash and cash equivalents was spent and $350 million of marketable securities was nearly wiped out.
Revenue has been in decline since the end of fiscal 2011, causing a steady decline in operating cash flow (shown below). Many of its biggest segments including "Global Tech Services" and "Global Business Services" saw declines of nearly 2% while its "Systems and Technology" segment has declined a striking 16.6% so far this year. Only its "Software" and "Financing" segments have seen growth this year of 1.3% and 3.5%, respectively. The lack of sales growth has not yet hurt profits because of IBM's disciplined cost cutting but this strategy cannot continue indefinitely. At some point IBM will have to stop cost cutting and increase (or at least stabilize) sales to maintain profits. Until IBM can accomplish that, investors will remain concerned about the future.
US Spying and its Impacts on IBM
IBM will be one of the most adversely affected companies as a result of the US/NSA cyber spying programs. The revelations have already caused China to shift away from US computer companies like IBM in favor of domestic or other international brands. This has already been felt at IBM, as sales from China decreased 11% in the last quarter, continuing a trend of decline that started three quarters ago. In addition to this, nations such as Germany and Brazil are taking added steps to protect themselves from US spying. They have not yet condemned IBM but other US companies like Verizon (NYSE:VZ) have lost business. Germany even mandated that the whole government switch to specially secured BlackBerry (NASDAQ:BBRY) devices, a Canadian phone. I stated earlier that IBM has faced shrinking sales for many years and that lower sales do not mean lower profits. However, if sales drop off in parts of Europe and Latin America as they have in China then IBM would be in serious trouble. Falling sales would ruin cash flows, harm profits and all the efficiency in the world would not save it.
IBM's management has implemented some good policies in recent years which have increased profits but have failed thus far to successfully increase revenues. This has led to the continuation of policies which, when spread over the long term, can severely diminish a company. IBM has laid off tens of thousands over the last few years, cut overall R&D spending, sold off assets and has aggressively bought back stock.
Laying off employees is necessary from time to time, but IBM has managed to greatly increase profits over the last coupe of years yet has planned to lay off another 13,000 in 2014. This causes two problems. First, it ruins company morale and job security for many people who then may not perform as well or switch to other companies. Second, layoffs are expensive and IBM expects to spend another $1 billion this year alone.
Another part of the cost cutting is the decrease in R&D. With less R&D IBM will be less likely to innovate on the scale it has in the past. So far this has not taken place but if cuts of 7%-plus per year continue then it's only a matter of time. IBM has also decided to move away from low margin high volume business like its PC "Thinkpads" in the mid 2000s. Recently it sold its low-end server business to Lenovo. This was an area where IBM could have expanded and dominated but that it no longer is a part of.
Lastly, in order to increase per share results (especially EPS) IBM has been aggressively buying back stock for many years. The upside is that the stock has been bought at a relatively low price and has greatly improved share results. However, IBM has spent nearly $12 billion on stock buybacks this year alone. That is nearly twice as much as the first six months of last year. They have done so largely using debt and the chart below shows the rise in debt at IBM. This is not sustainable especially when sales are in continuous decline.
Source: Google Finance
IBM has many upsides and downsides to it at the moment. If you have the stock, continue holding it for the dividends, buybacks and rising profits. But, be aware of the long-term risks of the rising debt, unsustainable cost cutting and falling revenues. For those looking to buy in for a long-term hold I would hold off until some stability returns to its revenues and expenses. IBM is certainly capable of returning to a stable operating norm with steady sales, profits and no mass layoffs. So far however, IBM has continued to increase risk in the long term by growing debt, selling off assets and decreasing spending on future breakthroughs. Mixed with international issues causing further decreases in sales there is much risk to consider when looking at IBM.
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.