Introduction - IBM (NYSE:IBM) Stay Away
Seeking Alpha readers know, particularly in the wake of IBM's earnings announcement last week, that the shares have become quite controversial. Analysts, as well, are split pretty evenly on the name. IBM shares have a 3 rating, which is right in the middle of the Thomson/First Call scale with a mean price target, for what it is worth, of $132. Few analysts or contributors apparently changed their minds in the wake of the earnings release. They simply became more convicted and vociferous in expressing their views.
I think if I might summarize the bull case, it rests on assumptions that IBM's "Strategic Imperatives" sector, now representing 36% of revenues, will change the growth profile of the company, that revenue growth matters little to a company such as this, that IBM's growth problems are functions of divestitures, and that the company has a superb balance sheet with strong cash flow generation, and a generous dividend that produces a 4% yield. Some of that is true, of course. The company does generate lots of cash relative to its earnings stream - that is pretty typical of companies that aren't growing - they simply do not need more capital to stay in the same place. And of course the yield is 4%. Again, companies that aren't growing should and mainly do pay out a high proportion of their earnings in dividends - they simply can't find places to reinvest the cash they generate.
Sadly, however, the rest of the case is basically either untrue or the product of a hall of mirrors. IBM shares may sustain current valuations because the current shareholder base is far more interested in income as opposed to growth. IBM may, or may not, achieve the rather modest objectives it set for itself during the course of its earnings release depending on macro factors, the company's ability to execute, and competitive pressures. I don't purport to have the tools to handicap the most likely results for current quarter or the one after.
What I can state without much fear of being proven wrong is that the company is suffering significant and long-term market share losses in the key business units in which it operates. These market share losses are self-evidently the product of past wrong decisions and poor execution coupled with an inability to try to lead the market. IBM, despite its significant R&D budget and significant innovations such as Watson, has basically become a follower and not a leader in the tech space. And followers, in my experience, are rarely good investments.
There were no signs of hope in the last reported quarter - market share trends were abysmal almost across the board. I think readers would do well in this case to wait for evidence; any evidence that IBM is at least stabilizing its market share position before making commitments to the name. No, I don't expect that the dividend is in any danger or that cash flow generation will collapse - but losing market share quarter after quarter is surely not the way to sustain the franchise, and at some point, something is going to have to give. Stay away until there is some clarity about what IBM can do and will do to reverse its endemic market share declines.
Investment Thesis - Market Share losses can't be disguised by growth in "Strategic Imperatives"
Almost the entirety of my thesis and analysis of this company rests on its market share performance. It isn't as though you can go to something equivalent to Ward's Automotive Reports and see market shares printed in a neat and concise package. And IBM's revenue presentation, while most likely not designed to obfuscate, makes figuring market shares more than a little involved and convoluted. I promise not to try to go through the calculations I have made in order to comment about market shares. Long articles are articles that aren't read so for now, anyway, I will keep things pretty simple and hope my readers will indulge me not presenting quite all of the data.
These days, IBM operates in two broadly defined categories that account for more than 85% of revenues. To make things simple, I will lump all of IBM's services offering together even though the segments have different financial characteristics. Services in total account for more than 55% of IBM's total revenues, and they shrank by about 2% last year in constant currency and excluding divested businesses with that trend continuing into the just reported quarter.
IBM's software business declined 4% in constant currency for the year and 6% for the quarter. I will discuss some market share metrics below in a little bit of detail - but if anyone sees some comfort in these numbers, I would be surprised. If IBM's market share is going to turn around any time soon, the evidence for that turnaround just simply isn't here in the high level financial reports. Night just doesn't turn into day because you like bright sunshine.
Again, simply put, at a high level, IBM revenues shrank, and the revenues of its competitors in its key business segments increased. That is not the trend that most tech investors are likely to find acceptable, and if it isn't fixed, some of the things that value investors do find attractive at IBM will ultimately come undone.
Services - No Signs of Turnaround here
IBM operates two major service business. One is what it calls Global Technology Services (GTS) which is basically consulting. The other business is called Global Business Services (GBS), and it is basically providing users with an outsourced managed IT service, i.e. IBM builds and operates data centers for its clients. Needless to say, margins are higher in consulting than in providing managed services, although to a certain extent, managed services drag some IBM hardware along for the ride.
One of the confusing things about IBM's revenue presentation is that within services are lots of the revenues for what it calls "Strategic Imperatives." We just don't know how much revenue in services is also part of the strategic initiatives bucket. The two largest strategic imperatives are analytics and the cloud which together accounted for $28 billion of revenues last year or more than 80% of the revenue in that category. Just to muddy the waters a little more, IBM actually reports the revenues within strategic imperatives in an overlapped fashion, i.e. when it sells an analytics solution that is also a cloud deployment that counts twice. How much the overlap is not reported - just the fact that it exists. Further, a significant component of the growth numbers in strategic imperatives come from acquisitions such as Cleversafe, Clearleap and Bluemix as well as the digital part of the Weather Channel. So it is next to impossible for an outside observer to really know what the organic growth rate of strategic imperatives has been and even exactly how large that revenue segment really is. But let's move on.
When IBM reports its services revenues, it already includes revenues that encompass analytic solutions and cloud deployments. How much? We aren't told. But the math alone, given what else IBM sells, suggest that a preponderance of the revenue coming from strategic imperatives is found in the services buckets. And with that strong tail wind, revenues in services are still declining!
There are some reasons for that. Loads of what IBM does in services is basically outsourcing and maintenance. And it is hard for IBM to compete against the Indian vendors in those areas. The Indian companies simply have lower costs and most American IT managers believe that they have equal or superior service delivery capabilities when compared to American-based competitors. Of course, IBM has large installations in India. It has been in the country since 1952 and after a hiatus in the 1970s during the worst of India's socialist phase, it reentered the country, seemingly for good in 1992. By some estimates, it has 30% of its worldwide workforce in that country and a higher proportion still of its consultants are Indian. Partially because of the take-off of the Indian outsourcing vendors just after the turn of the millennium, IBM ramped its Indian presence extremely rapidly - from 9,000 in 2003 to 74,000 5 years later, with growth continuing beyond that point until 2010. But it still manages to have higher costs and it continues to lose share points to its major Indian-based competitors. Last quarter, IBM services revenues contracted marginally. The 3 largest Indian competitors grew as follows: Tata Consultancy Services (OTC:TTNQY) 5%, Infosys (NYSE:INFY) 11%, and CTSH (NASDAQ:CTSH) 14% - preliminary number inferred from a press release. Again, if there is some rainbow or sunrise in IBM Services results, it is really hard for me to find it.
One further comment here. Much of what IBM reports as the cloud, particularly in services, is no more or less than straight cannibalization. IBM has an active and efficient press office that puts out a flow of news releases regarding wins. Just a brief perusal of the recent releases will bring home the point. Where heretofore, IBM would win its share of business outsourcing the operation of on-premise data centers for its clients, now it competes to operate cloud data centers for the same clients. What it really amounts to is that cloud outsourcing revenues are rising, partially organically and partially through acquisition and on-premise work is falling at faster rates that wind up producing about the same amount of dollar revenue. One doesn't have enough data with which to make an unassailable conclusion, but regardless of how you slice and dice the numbers that are available, it is pretty clear that cloud is not really a growth driver for IBM. What appears to be happening is that the company is simply replacing on-premise business with cloud solutions and that is not growth.
Software - What revolting results these were
IBM has always been a software company. It sells operating systems and middleware and has done so for many years. But what most observers think of when they think of IBM's software businesses are the companies it acquired in a burst of energy just after the turn of the millennium. No way I could possibly list all of IBM's software acquisitions, but they include companies such as Tivoli (acquired 1996); Ascential Software (acquired 2004); Cognos (acquired 2007) Rational Software (acquired 2003); SPSS (acquired 2009); Unica (acquired 2010). Sadly, for investors and this author as well, we do not know, because IBM doesn't report it, how the different segments of its software business are doing these days in terms of actual dollars as opposed to percentage changes. IBM calls most of the software it sells either branded middleware or other middleware with the distinction left to the reader's imagination.
It would, for example, be interesting to know what is included in Information Management solutions bucket that declined by 5% last quarter while what IBM calls analytics was increasing by 16%. Cognos, which along with SPSS, are presumably the components of the information management space that is supposed to sell big data analytics last time I heard - clearly there is a disconnect in definitions. Do I think the disconnect is deliberate? Not really. I simply am not big on conspiracies, although on occasion I have certainly seen software vendors rejigger their segment definitions to present a better picture to investors. It would certainly be interesting to understand how part of the analytics stack - the software analytics product component - was down by 5%, but the entire stack was up by 16%.
Most frightening of all, however, was the stunning 28% decline revenues at Rational Software. Rational is a company that sells application development tools. It is conceivable to me that in this age of the cloud, and most particularly SaaS, users aren't developing so many applications and they do not need Rational tools. Or perhaps, the case was some big deals slipped or that sales execution imploded. Take your choice, none of the potential reasons is particularly comforting. Of course, I have no definitive answer and the company has not suggested a complete explanation.
Management has spoken to the impact of the cloud on its reported software business in the sense that as users have switched to cloud deployments and abandoned buying perpetual licenses, it is impacting revenues. But here is the rub for me. The same process is at work at both Oracle (NYSE:ORCL) and SAP (NYSE:SAP). And the results, all reported in constant currency, are that Oracle product revenues were up 5%, SAP's product revenues rose 11%, and IBM's product revenues in its software space were down 6%. The cloud is having profound impacts on the financial results of everyone in the IT marketplace and many of those impacts are not immediately favorable for the vendors. But whatever else seems true, is appears to me that neither the swing to analytics or the trend toward cloud-based application delivery whether "true" or hybrid is helping IBM. It is continuing to lose significant share points in software and there are certainly no signs that I can see of a reversal any time soon.
Conclusion - Still an Unhappy Tale
IBM has become a particularly controversial investment in the wake of its most recent quarterly report. There are observers both amongst Seeking Alpha contributors and analyst who believe they see signs of life amongst the wreckage and are willing to take a chance on buying the shares at current levels of around $122. They feel that many investors do not understand IBM, that the growth in IBM's strategic imperatives segments is a hopeful sign for the future and that investors overemphasize concerns about revenue growth when they ought to be focusing on the company's balance sheet, its massive cash flow generation, and its generous dividend that affords a 4% yield at current share prices.
While it is possible that the downside for IBM shares is limited given the likely massive turnover in the shareholder base and the modest expectations of those new shareholders, I feel that making commitments to IBM shares at this point would be an error. The company continues to hemorrhage market share both in its services sector and in the software sector as well. The company appears to have little in the way of proprietary and defensible technology. (Just to be perfectly fair, I think Watson is potentially earth shaking at some point and the acquisition of the Weather Channel potentially enhances that technology. And some of the companies that IBM has bought and continues to buy in the cloud do have interesting and unique solutions. But it is impossible to buy IBM because of the opportunities of Watson - it just starts from such a small base.) It would appear to be executing sluggishly and to be losing its past luster. Choosing IBM is no longer either the safe solution or the obvious solution. I do not believe that risk/rewards favor investors at the current time.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.