Is IBM's Software Segment Dying?

| About: International Business (IBM)

Summary

IBM reported FY 2015 revenues in line with IOI’s worst-case projection. Profitability appears to be just at IOI’s best case projection of 16% Owners' Cash Profit (OCP) margin.

After-market sentiment was hurt by IBM’s currency-inclusive projection of FY16 operating earnings of $13.50 / share vs. Street expectations of $15.

We are not concerned about currency translation effects but need to reassess our assumptions for near-term revenue changes given the continued weakness in software.

Our research will focus on software segment demand, near-term revenue projections, and overseas profit repatriation issues.

IBM IBM (NYSE:IBM) announced a "Tale of Two Cities" earnings report after hours on Tuesday 1/19. For profits, it was the best of times, for revenues, the worst of times.

Street analysts had developed projections of sales and profits that IBM beat for this year but disappointed for next. IBM's guidance shortfall sent shares lower after hours, and the stock is now trading just at the level we identified last July as a critical one with respect to market risk as measured on a price-to-sales basis ($120/share).

Against IOI projections, IBM generated revenue declines in-line with our worst-case assumptions for this year (down 12% from FY14) but Owners' Cash Profit (OCP) margins that appear to be just at our best-case projected level of 16%. We will not be able to make a more accurate estimate until IBM issues its annual statements, as the company did not publish full statements of cash flows with its earnings announcement.

IBM generates more than half its revenues overseas, and the surge in the U.S. dollar over the last year had a lot to do with the poor results. On a "constant currency" basis and excluding the effect of divestments, revenues fell by 2% on a year-over-year (YoY) basis.

While IBM's Cloud offering revenue growth appears strong, its "middleware" franchise saw a continued fall which concerns us.

This note explains our sanguine attitude toward currency fluctuations in IBM's case and our circumspection regarding the weak demand for IBM middleware products. We also discuss the effect of these factors on our fair value estimates and on our investment strategy.

Currency Fluctuations

Currency fluctuations are difficult (impossible) to predict and can make a great deal of difference in reported nominal amounts. They also can cause real liquidity and solvency issues if a company is not properly hedged. For instance, if a company generates revenues in one currency but must pay costs in another, if the currency in which its revenues are generated falls in value versus the currency in which its costs are denominated, profits to owners will be squeezed. If the move is drastic enough, a company in this situation can go bankrupt, as occurred in the Mexican peso crisis of the mid-1990s.

IBM is not in this situation. It generates a large proportion - over half - of its revenues overseas, but its overseas costs also are denominated in the foreign currencies, so it has what is termed a natural hedge.

In addition, IBM chooses not to repatriate its overseas profits, but instead socks them away in low-tax jurisdictions. As long as the company continues to do so, it will not lose the economic value of those profits, so they are, in some extent, available to owners.

The only case in which IBM might run into trouble regarding its offshore profit hoard is if it needs to repatriate cash in order to pay dividends or buy back shares. At present, it does not appear that this is an imminent threat to IBM, but it is one area into which we will delve when we speak to management.

Middleware Weakness

While we have understood that IBM is transitioning its business portfolio, the 6% decline in YoY software revenues measured on a constant currency basis were more extreme than we had expected. The Software segment makes up only 28 percent of IBM's revenues but a full 57 percent of its profits, so the prospect that demand for IBM's highest profitability products is waning would be concerning.

As you can see from the table below revenue drops in its Rational franchise were especially severe.

Product

Revenue Change

WebSphere

-5%

Information Management

-5%

Tivoli

-1%

Workforce Solutions

-4%

Rational

-28%

Key Branded Middleware

-6%

Total Software

-6%

Click to enlarge

There are three scenarios that could explain this revenue decline:

  1. IBM moving to new licensing model that allows clients more flexibility in its software consumption.
  2. IBM moving what had been sold as installed software to the Cloud ("Platform as a Service" or "PaaS").
  3. Demand for IBM's middleware offerings are in decline.

On the call, management hinted that the first effect was indeed occurring and called the change good for customers. (1) IBM middleware offerings compete against Oracle's (NASDAQ:ORCL) middleware platform, and Oracle is notorious for inflexible licensing terms, so it is possible that IBM's flexibility is a strategic move aimed at strengthening its long-term competitive position by winning away some of Oracle's clients.

We suspect that the sharp drop in Rational's revenues is based on a shift of this product line to the Cloud as part of IBM's emphasis on its so-called strategic imperatives. IBM reports that revenue growth in the strategic imperatives businesses is growing well, but gave statistics for strategic imperatives as a group rather than showing how its growth offset falls from other parts of the software business. Because of this representation, it is hard to be sure how much of the Rational revenue loss (or any other product for that matter) was offset by Cloud gains.

As for the third scenario, management reported that some of its larger deals are taking longer to close than expected. We think these delays hint at flagging demand, perhaps related to weakness in the energy markets and/or softness in China and other emerging markets.

While the revenue picture was not pretty, IBM's margin improvements at the firm level provide some evidence that the issues facing the software segment are complex and not totally negative. Higher margins and profits per share (2) suggests that even if demand for IBM's middleware is softening somewhat, the revenue stream from strategic imperatives is being converted into profits at a higher rate.

Revenue data regarding strategic imperatives looked strong, but note that these revenues are spread over several of its segments, not only software.

Area

2015 Revenues (USD billions)

YoY Change

Analytics

18

16%

Cloud

10

57%

Mobile

3

250%

Security

2

12%

Social

1

21%

Click to enlarge

Considering these data, we believe the strategic imperatives are helping to improve efficiency and increase leverage across multiple business lines, such that IBM's future profitability profile will be less dependent on the software segment as such. Because the other business lines also are in transition, however, this is not yet visible on the segment level.

In the end, the 4Q conference call brought up more questions for us than it answered. While our worst-case FY 2015 revenue growth projections proved to be accurate, our projection for a 5% YoY revenue decline this year may have to be revisited, especially considering the company's guidance regarding currency effects.

Fair Value Impact and Investment Strategy

IOI develops fair value ranges with a total of eight valuation scenarios given three main valuation drivers: near-term revenue growth, near-term profitability, and medium term cash flow growth.

The projections we made at the middle of 2015 for IBM's value drivers were as follows:

Revenues

(5-year CAGR)

Best Case

1%

Worst Case

-2%

Profitability

(OCP margin)

Best Case

16%

Worst Case

13%

Nominal med-term FCF growth

Best Case

GDP

Worst Case

GDP +2%

Click to enlarge

The combination of worst-case revenue growth, best case profitability and best- and worst-case medium term growth worked out to a fair value of $198 and $212, respectively. However, revenue CAGR estimates included FY 2015, which has now been booked, and we need to assess our outlook for the next five-year period before making any change to our fair value range.

As IBM's shares decreased over the past few months, we have considered increasing the size of our investment in the company and/or slightly increasing our leverage in the investment. At present though, the questions surrounding the software segment's demand environment and the larger issue of whether we have built enough future revenue declines into our valuation scenarios make us particularly hesitant to do so.

Our research on IBM will focus on a few key questions:

  1. Demand dynamics for the software business - especially for middleware products.
  2. The reasonability of our worst-case revenue projections given continuing declines in the top line of each of IBM's segments.
  3. The extent to which the firm's dividend payments or share repurchase program may be affected by the need to repatriate foreign profits.

We will publish an update as soon as we have come to a conclusion on these questions.

NOTES

1. This comment prompted one analyst to make the point that, if given their druthers, clients would prefer not to pay for software at all and ask to what extent IBM was willing to be generous to their clients.

2. See our report IBM's Profits Hit an All-Time High for details.

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.