Analyst Katy Huberty of Morgan Stanley raised her rating on IBM (NYSE:IBM) shares from equal-weight to over-weight. In addition, The Wall Street Journal Heard on the Street Column printed an article suggesting that IBM shares, because of their valuation and negative analyst sentiment, have nowhere to go but up. Curiously, at least from my perspective, the Morgan Stanley price target for the shares is now $140 which is just a bit more than 5% above the current share price and just $5 greater than the old price target.
I'm not sure about how readers might feel about changing a recommendation based on a 4% increase in price target, but to some extent, I have to think that the word "outperform" ought to suggest more than a 5% move. To be fair, the shares have increased by 5% today before the announcement of the recommendation. On the other hand, the shares had retraced more than 65% of their most recent downward move in the three-day rally that came to an end this afternoon.
IBM is not thought of a particularly volatile stock and indeed, its Beta is 0.66. So the fact is that 5-6% moves in a single day or even over three days are more volatile than many observers might anticipate. There is obviously a fair amount of controversy regarding the prospects of the company in the next couple of years. Again, somewhat remarkably I thought, the Morgan Stanley analysis suggests that IBM is to return to top line growth by 2019. Really! To be fair, the analysis does forecast growth in free cash flow of 2% between this year and 2018. Amazing!
As I understand the analysis and the recommendation, it is predicated on the more rapid growth of the revenue cohort that IBM describes as strategic initiatives vis-à-vis the rest of the company. In addition, the analyst describes IBM as undervalued when compared to what it describes as a peer in Microsoft (NASDAQ:MSFT). The report suggests that there is a faster than expected transformation to higher growth/higher value solutions.
A few weeks ago I wrote a report that addressed some of these subjects that was titled IBM: Far Less than Meets the Eye. I tried in that article to touch on some of the points that are made in the Morgan Stanley analysis but reached substantially different conclusions. I really haven't seen much in the interim that would change my mind regarding evaluating IBM. About the only things that I have seen in the interim are disappointing results from companies that sell desktop visualization software and results from some of the professional services vendors such as Cognizant (NASDAQ:CTSH) and Virtusa (NASDAQ:VRTU) that suggest that on a relative basis, the IBM position in that revenue segment is even worse than I thought might be the case.
IBM has an analyst meeting scheduled next week and the report goes on to suggest that the meeting is likely to be a catalyst for the shares. Some years ago I might have been inclined to put more stock in the value of analyst meetings as a share price catalyst. These days, due to compliance concerns, it is rare for companies to disclose much of anything one way or the other during analyst meetings and I doubt that IBM will do much more than to reprise their past presentations.
I obviously do not know how Q1 might turn out for IBM compared to guidance. It is going to be two more months before the company releases its financial results for Q1. I suppose if I had to guess, it would be that conditions for IBM have deteriorated a little and that bookings and revenues might continue to miss expectations although the company has a record of sustaining earnings despite revenue misses. In the month or so since IBM reported, there have been more than a few high-profile IT companies that have become more cautious in terms of guidance, suggesting that a deteriorating macro environment might be weighing on the decision-making of their customers.
But my overall thesis is that IBM has been losing market share and that its execution capabilities seemed to be in long-term decline. I haven't seen anything either substantive or written about that might cause me to change my opinion.
The Morgan Stanley analysis starts by suggesting that comps for IBM ought to be with other hardware companies or with Microsoft, but that is really a pretty far stretch. These days, systems hardware is less than 10% of IBM's revenues and IT services of various kinds are about 55% of total revenues, followed by software which is nearly 31% of total revenues. How IBM might compare to HP (NYSE:HPQ) or EMC (NYSE:EMC) or some other real hardware vendors would seem to me to be far less important than how IBM compares to Cognizant or Infosys (NASDAQ:INFY) or Oracle (NYSE:ORCL) and SAP (NYSE:SAP). I think that comparing IBM to such competitors - and those are IBM's real competitors - would yield very different conclusions than those embedded in the Morgan Stanley report.
Analysis-A Biopsy of a Sick Competitor
I don't intend to discuss anything other than IBM's efforts in IT services and software and try to compare its results to the extent that I can to other vendors in the field. It is really not worth the time or the space to try to analyze a 10% segment of IBM's business that is self-described by the company as non-strategic. So how well is IBM doing in both of these two areas? The simple answer is not very well at all and there is no reason to think change is coming anytime soon.
Overall, IBM revenues in IT services shrank 1% last quarter and shrank by 6% in software. Both of those numbers are expressed in constant currency. How well did the competitors do? Well, Cognizant grew by 18% although 400 bps of that was the result of an acquisition. Accenture (NYSE:ACN) grew by about 8% in constant currency, Infosys grew by 9% and Tata Consulting grew by 12%. It is just hard to dismiss these figures as meaningless - they have happened and there is no evidence of any kind that I have seen to say that IBM is all of a sudden a more formidable competitor in terms of competing with these vendors than has been true in the recent past.
OK, but what about all of the transformational activities that were cited in the Morgan Stanley report? Last year IBM sold $18 billion of analytics solutions, most of which were part of its $50 billion of revenues that came from its various consulting buckets. It also sold $10 billion of cloud solutions although there is some double counting in those numbers as lots of analytics were part of the revenue counted as cloud. Why the statistics are presented that way, I simply do not know. The overlap isn't insubstantial - it actually amounts to $5 billion but I really do not know in what buckets the overlap resides.
But one thing I think I know for certain is that almost all of IBM's analytics revenues are derived from its consulting practice. It is just simple math to make that assertion. But the fact is that the other activities in which IBM participates that might be called analytics which include its Netezza Big Data Appliance, its Cognos and SPSS business intelligence and analytics software products and all of the other acquisitions in the analytic space along the way that were primarily software are declining. If analytics is a strategic imperative component for IBM the question has to be why can't it sell analytic software solutions?
IBM still remains the largest consulting company in the world and the environment changes such that consulting demand switches to the realm of analytics. Does it mean you are transforming the company if your consultants who used to do ERP implementations now do projects that are labeled as analytics? Does it mean you are ahead of the curve in analytics? The fact is that if analytics is primarily consulting and IBM grew analytics by 16% last year, what does that say about the rest of the company's consulting practice? Remember, overall consulting revenues fell by 1%. If overall consulting revenues were about $50 billion and analytics were $18 billion of that figure, what must have happened to the other $32 billion? Well if analytics was up by 16%, then math says that the rest of the consulting business had to slip by 8%. If management of the company is doing such a great job in terms of emphasizing strategic initiatives such as analytics, then is it fair to say that management is doing a terrible job in maintaining the revenues from IBM's "legacy" consulting assignments?
I think it is terribly difficult to explain why and how the deterioration in IBM Consulting vis-a-vis its competitors is going to turn around unless IBM has done something unknown and mysterious to improve its competitive positioning.
The same kind of analysis leads to identical conclusions when it comes to software. Overall IBM software fell by 6% in constant currency during the quarter. How does that compare to Oracle? Simply put, not that wonderful, because Oracle grew its software revenues by 6% in constant currencies last quarter and that was considered by most observers to be quite disappointing. And how about SAP? Well, the comparison is even worse as SAP software revenues grew by 11% in constant currencies. One doesn't need an advanced degree in business analytics to conclude that something is seriously wrong with IBM's software business.
But really - can that matter all that much? Isn't IBM focused now on selling cloud software solutions and could that be an answer to its performance? There are very few software vendors these days who do not try to sell cloud. That is what their customers want and it is a significant revenue opportunity over the long term. I don't imagine there are very many observers who do not realize that cloud applications will wind up with customers paying vendors more than would otherwise be the case.
IBM reported that its cloud revenues grew by 57% year-on-year and reached $10 billion. Some part of that is consulting. In my analysis above I actually was not pushing the case as hard as I could. How much is consulting? I really don't know but perhaps it was half of what IBM describes as cloud revenues. The rest is software. So, using those assumptions, cloud software revenues grew $1.8 billion last year and the other component of software revenues which is still producing $22 billion in annual revenues must have fallen by 15%. Might one uncharitably observe that this is one of those situations in which the operation was successful but the patient didn't wind up so well?
Again, if analytics is important to IBM and it is a key transformation initiative, then how is it possible that Information Management software fell 5% last quarter? Could it be that what IBM describes as information management software is not competitive and is not sold properly and that IBM will need to do a series of acquisitions to develop a competitive offering?
I have had the occasion during a relatively long and varied corporate career in which I have had to explain many conundrums to all different kinds of managers. But I'm certainly glad not to have been involved in trying to explain something like this.
Some Comments About Free Cash Flow
It is my belief that most of IBM investors these days don't really care all that much about just how badly the company is doing in terms of maintaining its market position - they mainly care about free cash flow and dividend yield. I confess that as a tech investor and analyst of many years standing I find such a motivation very difficult to understand but that is a philosophical discussion which is unnecessary to pursue at the current time. What I can say is that IBM's free cash flow is partially a product of its poor performance. Although IBM continues to sell a bit of hardware, that is no longer a focus of its business. It basically sells consulting services, managed IT services and software. These are not normally thought to be capital intensive businesses and their capital requirements all have to do with growth in terms of facilities or working capital and not capex. The only capex that IBM really has to fund these days is that of some selected facilities. I think it is evident that IBM continues to have surplus facilities. There are specific facilities such as the company's new cloud center in which IBM is investing. But overall, IBM will need less facilities and not more as it continues to shrink. The same is true with regard to working capital. The other major use of funds in a cash flow analysis for a company selling software and services. And here too, the requirement for working capital is going to decline gradually as IBM continues to shrink.
My point is not that IBM doesn't generate lots of cash and free cash or that it will cease to do so in the future. But lots of that splendid cash flow beloved by investors, presumably including Warren Buffett, is not a product of skillful company management on the part of IBM but is a consequence of the shrinkage of the company. I just do not think it's sound logic to buy IBM shares because its cash flow is rising 2% under the Morgan Stanley scenario. The fact is that all and more of that 2% is a function of the excess working capital and depreciation that is generated because of the company's shrinkage. I really would find it hard to explain to institutional investors why they should value IBM more highly because its shrinkage is leading to a growth in free cash flow.
I might finally observe that it seems to me that IBM's solution for some of the obvious product shortfalls is its acquisition strategy. I have nothing against an acquisition strategy in the IT space - it is a very profitable strategy and the stack vendors have, from time to time, been very successful in finding expensive companies to buy that turned out to be great bargains in the end. If IBM doesn't have competitive software products in the software analytics space, then today's purchase of Truven Health Analytics makes loads of sense. If IBM feels that putting together multiple companies in the space such as Truven and Merge Healthcare and adding them to its Watson platform is going to aid in its transformation, I would have to say that is a sensible strategy to me.
If IBM has decided it wants to pursue the online-ad agency space by buying companies such as Aperto and Resource/Ammirati to become the largest digital agency, I again think that such a strategy seems quite reasonable. But in the nature of things, acquisitions are expensive. Free cash flow last year was $13 billion and the company spent more than $9 billion buying stock and paying dividends. The company has $8 billion in cash. But it is easy to run through that reserve fairly quickly if IBM has determined that the only way it can stabilize and grow revenues is by filling its product holes through acquisition. The Truven acquisition cost $2.6 billion. IBM spent well over $2 billion to buy the digital assets of the Weather Co. lase last year. Investors who own IBM because they believe that its dividends will increase steadily over the years might take a look at the transformation strategy that most likely will be built on a host of acquisitions in the strategic spaces and wonder how that bodes for their expectations.
Conclusion: Does IBM have a hidden value hiding in plain sight?
Quick answer - if it does, I do not see it. IBM shares are cheap, but they are cheap because the company isn't growing and it isn't likely to grow. After today's 5% rally, the shares are selling just below 10X earnings and around 1.9X EV/S. Oracle, which isn't my favorite stock either, has a P/E of under 13X. Cognizant, which has double-digit growth, has a P/E of 14.5X and an EV/S of about 2.2X. INFY on the same basis has a P/E of 14X and an EV/S of 3.2.
Some investors choose to look at simply the raw valuation metrics and ignore both the growth prospects and the composition of the valuation metrics. I feel that such a strategy is likely to yield sub-optimal investment results over the long run. A company with stable revenues may not be a bad investment in a stable industry. There is nothing at all stable about the IT industry.
I suspect that IBM management will do everything in its control to renew growth. And if that means spending huge sums of money on acquisitions that will not be either surprising or necessarily a bad thing. But renewing growth is going to be costly from the point of view of acquisitions and ultimately increased marketing and R&D spend and probably through a longer term reduction in gross margins.
Maybe IBM management is capable of hyping its shares at the analyst meeting next week. I have no doubt that company management is up to the challenge of selling its stock, at least in the very short term. But what management might say that would be both credible and quantifiable about a strategy that was leading to a recrudescence of organic growth, I simply do not know. I continue to believe that there are better large-cap technology names that ought to be considered in an investment portfolio such as SAP or Infosys that are focused on maximizing growth consistent with reasonable margins.
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.