IBM Earnings Preview: Free Cash Flow Yield Is 11%

| About: International Business (IBM)

Summary

Downward pressure continues on forward revenue and EPS estimates.

The stock is trading with an 11% - 12% free cash flow yield.

The $125 area is the 200-month moving average.

As legacy businesses get crushed, future growth is about the Strategic Imperatives segment.

Currency is really impacting revenue: high single digits negative translation for the last four quarters.

It's hard to find a stock outside of the Energy and Commodity businesses with the combination of declining forward EPS and revenue estimates, horrible sentiment and ugly technicals. But if there is one, it has to be International Business Machines (NYSE:IBM).

This stock is hated for good reason as the legacy consulting and services businesses are rapidly becoming obsolete while the Strategic Imperatives businesses, mainly the Cloud, Analytics, etc., are still not big enough to move the needle for IBM.

When IBM reports their calendar Q4 2015 earnings tonight, January 19th, 2016, after the bell, Street consensus is looking for $4.81 in earnings per share (EPS) on $22 billion in revenue for expected year-over-year declines of 15% and 9%, respectively.

From my internal spreadsheet, it has been 2011 since Big Blue has seen two consecutive quarters of positive revenue growth.

Yowser...

For calendar 2016, current consensus is expecting $14.96 in EPS on $79.4 billion in revenue for expected full-year flat EPS growth and a decline in revenue of 3%.

IBM isn't expected to show y/y growth until 2017.

Here are some quick notes from Q3 2015:

  • IBM revenue fell 14% but constant currency revenue declined just 1%.
  • Strategic Imperatives, roughly 28% of the business today, is growing at roughly 30% constant currency.
  • The Global Technology Services and Global Business Services - more than 50% of revenue are flat to down single digits in terms of constant currency revenue growth.
  • IBM Software is roughly 25% of the revenue and is seeing margin pressure - over 200 bps last quarter, which is similar to Oracle (NYSE:ORCL).
  • Signings were down to $7.2 billion in Q3 2015, down 7% y/y and one of the weakest numbers in years.

In fact, IBM is facing the same dilemma that faced the tech growth giants of the 1990s: how to invest in technology segments with secular growth, to replace fading legacy businesses and do it intelligently over a period of years.

Ginny Rometti is facing a huge challenge with rise of the Cloud and the commoditization of big data.

That being said, there is one positive to Big Blue:

CFFO y/y gro FCF y/y gro
9/30/15 $18.9 34% $15.0 50%
12/31/14 $16.1 +3% $12.0 1%
12/31/13 $15.7 -6% $11.9 -35%
12/31/12 $22.5 9% $18.2 10%
12/31/11 $20.7 6% $16.6 5%
Click to enlarge

Revenue in billions, with all numbers "four-quarter trailing."

CFFO = cash-generated from operating activities

FCF = free-cash-flow (CFFO less capex)

Cash flow story: What's interesting to me about IBM's cash flow "story" is that in 2011 and 2012 when the Street was gushing over the stock and it was outperforming the S&P 500, the cash flow generation and the buyback was the reason cited. Today the cash flow is almost dismissed as a negative, as legacy businesses erode, citing cash flow as a more of a "cash-cow, no secular growth" story, which could truly be the case.

Valuation: With the stock trading at 9(x) expected 2015 and 2016 earnings, and for roughly three years of negative EPS and revenue growth, there isn't much to like about IBM.

At roughly 7(x) cash-flow (four-quarter trailing cash from operations) and 9(x) free cash flow, and down nearly $100 from its early, 2013 all-time-high of $215, the stock looks cheap, but it has been that way for a while.

The intriguing metric is the 11% - 12% free-cash-flow yield, but without some kind of revenue and EPS growth, the cash-flow will eventually fade too.

One aspect to Morningstar's valuation methodology is that it takes a longer-term view of a company and sector and looks at the sustainability of the moat around the business. Morningstar's analyst states that IBM has "defensible positions" in enterprise software, IT services and hardware. With an intrinsic value estimate on IBM of $174 (which has been reduced from the low $200s) IBM is trading at a 25% discount to Morningstar's perceived intrinsic value.

What is important tonight:

Revenue guidance and in particular what IBM is looking for in terms of currency pressure. The fact is the US dollar index is still trading under 100 and hasn't made a new high since March 2015. Some of this currency pressure being felt by large-cap technology should start to diminish if the dollar continues to stabilize.

Guidance on the Strategic Imperatives business: I 30% of the business is growing 30% per year, then eventually it has to start showing up in forward estimates and growth rates.

Summary/Conclusion: IBM was cut in half for clients in the low $190s in the spring/summer 2013 as the stock looked toppy technically, and the remaining position has been maintained since, painfully I might add.

IBM has been through these painful technology transitions, in the late 1980s, early 1990s, from mainframes to PCs, then in the early 2000s to technology services, and now away from data management to the Cloud.

There is no saying IBM will make a successful transition either.

$125 is a rather substantial support level for Big Blue, on the monthly chart, but $150 also was a critical area and that couldn't hold.

This write-up is not a call on tonight's earnings in any way, shape or form. There is little to be optimistic about since forward EPS and revenue estimates continue to be revised lower for Big Blue. The Street seems to be looking for a third consecutive year of negative growth for IBM.

I was around in 1993 - 1994 when Big Blue traded down from a split-adjusted $43 in the summer of 1987 to the lows near $10 in the early 1990s.

That was grim.

If IBM can guide to just low-single-digit constant currency revenue growth tonight, I think it will help put a floor under the stock.

Disclosure: I am/we are long IBM, ORCL.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.