A Masterful Earnings Release
No, I don't mean that the quarter IBM (NYSE:IBM) printed was really good or that shareholders and other stakeholders should be happy. But the earnings release was masterful in attempting to portray a very mediocre set of numbers as something about which to be particularly happy and joyful. Just for the record, IBM reported revenues for Q1 of $18.7 billion, which is down around 4.6% year on year, but was $450 million, or about 2.5% greater than the prior consensus estimates. EPS was reported as $2.35, which fell from the $2.91 reported the prior year. On the other hand, earnings beat the prior consensus EPS forecast of $2.09 by 12%. And while I shall not reprise the balance of the headlines, I'll characterize them as more or less triumphalist and sadly not very realistic in informing either shareholders or any stakeholders with something even close to an evenhanded presentation.
Now I agree that expecting evenhanded presentations from companies is more or less like expecting Vladimir Putin deciding to make Russia into a human rights paradise. Not going to happen. There is an old verse from one of my favorite poets, Sir Walter Scott that goes, "Oh what a tangled web we weave when first we practice to deceive." The poem is actually about the Battle of Flodden Field, which the Scots lost - great reading particularly the part of young Lochinvar riding out of the west. As the reader will see, IBM's Q1 earnings release was quite a tangled web. But why so harsh on IBM? And why might I have called the earnings release masterful?
Before looking at some select portion of lots of numbers in detail, it is important to understand why IBM's shares are down - or at least why I think they are down. Fact is that the company cut guidance materially for earnings performance during the second quarter. The company has reduced its EPS forecast by $.60 from $3.45 to $2.85. Management maintained that somehow its new business structure is less weighted toward Q2 than heretofore. Most investors have seen that kind of shell game before, I imagine, and will wonder if the Q2 guidance reduction reflects more than is immediately apparent. No one really likes back-end loaded years.
You do not really have to go all that far to find out that the earnings number that was recorded was based on accruing a negative 95% tax rate for the quarter. Had the company accrued a normal tax rate of 19.5%, as it did in 2015, EPS would have been less than $1.00 share. IBM in its press release and on its conference call suggest that the company's profits were impacted by what one assumes to be one-time actions in which expenses were recorded for workforce transformation, real estate actions and actions in Latin America. When asked, the CFO actually refused to forecast that there wouldn't be more "one time" charges. At what point, I wonder, do one time charges cease to be one time and ought to be considered as a company's normal business operating practices?
Regardless of trying to reconcile what some might see as a series of one-time events that all happened to fall into this quarter, gross profits for IBM declined by more than $800 million, reducing the gross margin percentage from 48.2% to 46.4%. The decline in gross margins had nothing to do with work force or real estate actions or actions in Latin America. The decline in gross margins is the result of the company selling less software and hardware and an unfavorable mix change coupled with the purchase of businesses that have far lower margins than is typical for the balance of IBM.
As the decline in margins was broad based, in terms of segment reporting, I have to conclude that IBM no longer has the economies of scale that it once did or that price competition is more intense. Whatever the reason, and I am not saying I know all of the reasons, declining gross margins is simply not what I would want to see as the result of a transformation.
Now let's turn to revenues. It has been a very long time since IBM printed a revenue beat of any kind. The company CFO Martin Schroeder, who actually spoke for IBM on the call, commented essentially that he was "encouraged" by the quarter's sales performance. Needless to say, the point of view is in the eye of the beholder. I will address some of those issues shortly, but for what it is worth and from a 30,000-foot view, it would seem that almost across the board, IBM is losing market share. Why that is encouraging? I really do not know, but then again Mr. Schroder had very elaborate and segmented views of market share that make for turgid reading at best.
Management might do a better job in explicitly reporting the impact of currencies. The impact was clearly less this past quarter than in the preceding quarter. How much less is more than a bit difficult to determine. Management said that the positive benefit from the decline of the dollar was and will be offset in whole or in part by the cessation of the company's hedging activities. Trying to understand exactly what Mr. Schroeder might have been trying to convey, I think it is reasonable to expect that overall currency movements since the time IBM last gave guidance contributed several hundred million to this quarter's revenue. I believe that revenue performance was no better than in line although other readers of the conference call transcript might come to a different conclusion.
If transformational revenue growth is slowing significantly, then what pray tell is the transformation all about?
When I looked at IBM's earnings press release some hours ago, the first thing that struck me front and center was just how much growth had slowed in the company's strategic imperatives revenue bucket. Growth this quarter was just 14% year on year when compared to year-on-year growth of 26% for all of 2015. Yes, strategic imperatives are now 37% of IBM's revenues compared to 35% for all of last year, but that is as much a function of the decline in other revenues as it is a marker of success in strategic imperatives.
In fact, the results of some of the segments within strategic imperatives really made the segments look as though they were not strategic imperatives. Growth in every three of the four sectors of strategic imperatives declined in percentage terms. Most notably, Analytics, the second largest piece of strategic imperatives, had achieved 16% growth for all of 2015 - its growth rate in Q1 was 9%, both in constant currency. Perhaps as important as the raw numbers is what's happening to IBM's market share in analytics. We haven't yet seen the results from all of the other vendors in the space, but 9% growth, some of it inorganic is quite a bit below the revenue growth of the market as a whole. I won't drill down on every product space and comment on what might be happening to cause such a dreary result, but it is very hard to conclude other than that either IBM has inadequate products in the analytic space or that its sales execution model is quite flawed. Based on anecdotal checks, I will go with the latter.
The growth in total cloud revenues declined from 57% to 34%. Yes, total cloud revenues for the last 12 months are reported as $10.8 billion so perhaps 34% cloud revenue growth would be respectable. It is, for example, above, far above the 22% cloud revenue growth reported recently by SAP (NYSE:SAP). But if cloud revenue growth percentages are going to continue to decline, it is going to put this transformation at even more risk than already seems the case. IBM, perhaps because of this declining growth rate, decided to toss another number into the hopper, which is essentially what other companies report as ARR, or Annual Revenue Run Rate. The ARR in the cloud delivered as a service rose 42%. I suppose that if IBM continues to classify revenues enough ways, it will find a metric that looks good and try to focus attention that.
Just for the record, IBM's cloud revenues in total are larger than its principal cloud competitors. But again, this is another of those tangled webs based on what IBM means when it reports cloud revenues. Actually in trying to measure apples and apples, IBM is quite a bit smaller than Amazon (NASDAQ:AMZN) AWS (compare commercial cloud to IBM's SaaS business) and it is also smaller than Microsoft's (NASDAQ:MSFT) Commercial Cloud revenues. But additionally, for IBM, the problem is that both MSFT's commercial cloud and AMZN's AWS are growing at 70%. Market share is critical in the cloud space and 42% growth is less than 70% growth.
The other components of strategic initiatives are much smaller. Mobile increased by 88% partly because of acquisitions, but that was less than the 250% by which it increased in 2015. Security probably had the best quarter overall. Revenue growth of 18% was up from 12% last year, and management said it took market share. That there are companies within the security space such as Palo Alto (NYSE:PANW) and Fortinet (NASDAQ:FTNT) with far more rapid growth rates is indisputable. On the other hand, 18% growth is a respectable number for a company doing $2 billion/yr. in the security space.
I am worried about IBM's "legacy" business. Isn't that where all of the free cash flow is coming from? At what point does the company run out of leeway to keep raising its dividend and buying back shares if its legacy businesses continue to decline?
There are loads of numbers that might be considered in addressing that issue. It would require a paper rather than an article to fully address the subject. But I will try simply to address some highlights. It is important to note that IBM has reclassified the segments in which it reports revenue. The new reporting schema is said to align IBM's management structure with what is reported and I am sure it does that. But it has the disadvantage to observers in that it masks the comparisons and that it attempts to include the faster-growing businesses in with the businesses that are in secular decline. Another tangled web.
IBM's largest business remains consulting. IBM has chosen, wisely I believe, to exit certain parts of that business because it does not have a competitive cost structure to compete for more mundane everyday projects such as implementing ERP systems.
Because of the reclassification, IBM's investors will search in vain to find one or two revenue buckets that are simply consulting. That being said, bookings in Q1 for new service engagements fell by 17% year on year. And equally important, the backlog of service engagements continued to decline, albeit by a modest level. I do think that IBM has a reasonable approach to its consulting practices. At some point, it will shed all of the consulting sectors that are in decline. But how long will the transition last and what is the magnitude of the revenues that still have to be shred? Of course, I cannot answer those questions with any quantifiable precision. But it seems fair to say that it will be a while before bookings from the good new stuff start to rise faster than the bad old stuff disappears. That is what the CFO said on the call and it makes sense.
IBM's consulting business is losing share rapidly and it is in danger of losing its competitive relevance. We have one proof point regarding that in the results of Infosys (NASDAQ:INFY) reported a few days ago. Infosys enjoyed nearly 10% revenue growth and forecast that revenue growth would continue at that level for the balance of the year. Infosys is the second largest Indian outsourcing vendor. I think the difference in the operating performance of Infosys compared to IBM services is telling enough not to need further discussion.
IBM now reports revenues for a business unit it calls Cognitive Solutions which was flat year on year. Cognitive Solutions is a bit less than 25% of IBM's total revenues. Cognitive Solutions is the bucket where one finds Watson along with some consulting revenues that are based on Watson. Within Cognitive solutions, the strategic imperative revenue grew by 4%. No that isn't a typo - it suggests that we are a long way off from Watson and Cognitive Solutions being able to move the meter.
IBM's hardware business is what it is. It declined by 21%. The good news is that it now is less than 10% of IBM's revenues. It is really difficult for this writer to say any more than that about the Systems Segment.
IBM calls another new bucket Technology Services and Cloud Platform segment. This segment includes some software products as well as consulting associated with those services. It also includes the cloud and the consulting services that IBM provides for that revenue source. IBM has traditionally sold quite a bit of infrastructure and integration software. Its middleware solution is still declining, but its overall infrastructure services business actually grew by 4%, which, in the context of the performance of other IBM segments last quarter, is nothing short of a home run.
The basic problem for me is that strategic imperatives is already 45% of the total of this segment, and despite that, the revenue is growing 2%. This is the segment where IBM's cloud revenues emanate. Cloud is actually two-thirds of the strategic imperatives revenue in this segment and grew here at 50%. If two-thirds of IBM's segment business is cloud and that grew at 50% and yet overall growth of strategic imperatives in this segment was 45%, well then the rest of strategic imperatives in this segment are growing very slowly.
It is just hard to find any really positive trends in looking at IBM's business by segment. IBM is a long way from being a cloud company. The rest of its strategic imperatives are not growing at market rates and its legacy businesses continue their decline.
There is, as the CFO suggested, a significant level of inorganic revenue growth in the pipeline. He further suggested that IBM would remain active on the acquisition front. Acquisitions will at some point staunch the decline in IBM's revenue decline. But again, according to the CFO, they will put pressure on margins until they are absorbed and right sized. Indeed, part of the company's guidance perspective is just that - continued margin pressure from the absorption of newly acquired businesses.
It is apparent that IBM is a long way off from building a self-sustaining portfolio of cloud services and software that will allow it to grow. And so it is inevitable that the company will continue to invest very heavily in available acquisitions. The company spent $6 billion over the past 12 months in buying companies. Over the past 12 months, the company spent $3.8 billion on capex and another $9.4 billion on dividends and share repurchase. That comes to $19 billion of cash use. The company's net cash from operations was about $17 billion in 2015. IBM raised cash flow guidance from prior levels for all of 2016, but overall free cash flow is still supposed to be $2 billion lower than the results reported for the past 12 months.
The company has $15 billion of cash, but at some point, it becomes irresponsible to spend more cash than is generated. Yes, the company can always sell debt to enhance liquidity as it did last quarter, but raising debt to finance a dividend increase is really not a prudent financial strategy. If cash flow from operations isn't rising and the company doesn't want to spend more cash than it is generating, something has to give. Most likely, it will be the rate of share repurchase since acquisitions and capex are business necessities.
Some closing comments
I imagine that about now most readers are tired of any more numbers. But for those of you who have gotten to this point, one more number, please. Why does IBM have such a hard time in operating its businesses so that it doesn't continuously lose market share? On the call last night, the CFO talked about hiring 6,000 assets as part of the transformation process. He, of course, meant employees and people, but he called them assets. Simply put, I think that the company no longer acts as though it has any responsibility for the welfare of its employees. A very hierarchical business structure in which people are assets. An ossified response and decision-making structure that doesn't empower employees. Simply put, and solely in my opinion, IBM just does not run its business in a fashion that will maximize the value of the assets and the franchise the company still has.
SA Contributor Dana Blankenhorn recently wrote an article regarding IBM that he titled "All Is Lost At IBM." Perhaps I wouldn't have chosen such a dramatic title or nuanced some of his comments. IBM is not going to disappear. But the point of the article is that IBM as a business has dramatically changed and not for the better.
In analyzing what this quarter meant to IBM, it is important to look at the whys as opposed to the whats. The numbers suggest that IBM's transition still has a very long way to go. But the reasons behind the length of the transition make it less than certain the transition will ever get to its stated goals. There are investors who look for yield. IBM's dividend is secure, but I wonder if the company can afford to increase it. The capital intensity of the company's strategic imperative segments is reasonably low, and so cash flow is likely to be sustained. And of course the infusion of huge amounts of created cash into the world financial system is self-evidently creating an asset bubble of some kind, and IBM's share price has been partially influenced by that phenomena.
But companies that have structural problems in growing within the IT space rarely turn out to be decent investments, Companies that are losing market share in the IT space almost never turn out to be good investments. IBM is not growing its revenues, and it is losing market share. The earnings report last evening did nothing to change my mind on that point. Case closed, next case!
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.