As an IBM-watcher and sometimes long investor in it, I wrote several articles on IBM (NYSE:IBM) in 2013 and 2014 on Seeking Alpha, most of which were on bearish target (see below). This article is from the standpoint of a new money investor who is considering IBM shares versus other alternatives in various markets, or cash. There are many long-term holders of IBM who have large embedded gains, and given the uncertainties of all stock market analyses, assessments and forecasts, matters can look very different for those holders than for others. For these long-term holders, holding even if they agree with my points may be quite logical.
As we know, IBM announced a surprise set of charges in Q1, largely offset by a $1 B+ (after-tax value) win on a long-running tax dispute.
Layoffs and the like were the subject of several articles on IBM by me on Seeking Alpha in 2013 and into 2014, and briefly I turned bullish on IBM in 2014, thinking the worst was over and it could catch up to the raging bull market. But it did not perform operationally as I had hoped, and after that I began focusing on biotech so much for the rest of 2014 and 2015 that I did not write about IBM. Now I think it's important to do so, both on a company-specific basis and for what this might portend for the rest of the stock market (NYSEARCA:SPY).
A brief introduction to my neutral-to-bearish thesis:
IBM is unattractive at or near its current $148.50 price ($143 B market cap)
There are four major points that make IBM an "avoid" for me. These are:
- the company has lost its way strategically
- it continues to mislead investors
- it has insufficient mass in its strategic areas
- the cloud does not represent financial heaven
I'll take them in order.
#1 - IBM didn't know where it was, doesn't know where it is, and doesn't know how to get to where it wants to go
IBM has been downsizing for several years now, even though overall, computing was in a strong growth mode. That process provided a strong hint to me that the company was going to meet its 5-year EPS goals via cost cuts rather than real growth. As an industry blog said in 2013 about this ongoing process:
A byproduct of this business evolution is that IBM has been undergoing what they refer to as 'workforce rebalancing' over an extended period of time. IBM does not like to use the term layoff as this signals more of an immediate cost cutting response to a business decline, whereas IBM views their business as continually evolving over time to stay at the forefront of market trends and delivering the greatest value to its customers. But IBM's workforce rebalancing has essentially been a layoff of its higher salaried, long-tenured consultants located in high cost geographic areas offset by new hires of more junior resources, in lower cost geographic areas at lower salaries. This has resulted in lower costs and higher profit margins for IBM, and [is] a significant contributor to IBM's EPS performance growth...
We... have heard from more clients encountering challenges with the level of performance from IBM...
Contracting for commoditized IT services is a little like hiring a general construction worker who has studied and practiced all the individual carpentry skills (sawing, hammering, sheet rocking, etc.) but has limited experience building anything. When you ask them to build a one room addition to your house, will they have the ability to package those skills and manage the project, including foreseeable and unforeseeable issues, to achieve your desired result?
As IBM continues to commoditize IT services with delivery centers and lower cost junior resources, we recommend customers conduct more thorough due diligence to screen the resources assigned to their projects initially and on-going to best enable achievement of the desired results.
This and the parts I omitted for relative brevity are damning, and not just with faint praise. Imagine a mere consultancy heaping calumny on the once-mighty IBM by comparing it to an incompetent homebuilder! The idea was once unthinkable. Sadly, it's happening, and that was back in 2013.
Now, in Q1, IBM again surprised investors with an aggregation of more shrinkage - more "rebalancing" and also real estate shrinkage, and who really knows what else. While the tax victory that kept its GAAP earnings OK was as "one time" as it gets, these "special" charges are as recurring as "special" things can be.
What the need for more charges says to me is that IBM is similar to the IBM of the late 80s in that losses may be coming, as they did in 1991-93. This sort of recurrent shrinkage is troublesome. After all, by 2013 and certainly H1 2014, IBM was promising growth, not continued shrinkage. It needed an oracle to tell it where the future lay, but apparently its in-house oracle, aka Watson, was not up to the take. Meanwhile, other companies, large and small ones, seem to have seen the future better than IBM. IBM appears repeated to be skating to where it thinks the puck will be, only to find others got there first.
IBM has begun complaining that if only it could hire more security talent, it could grow faster. That does not ring true, if it really knew where it had to go when it should have known that:
Maybe they should have bought Palo Alto Networks (NYSE:PANW) several years ago. Or better, built their own equivalent with money saved by not buying back (overpriced) IBM stock. For a giant like IBM, which has been returning vast amounts of money to (selling) shareholders, the excuse that they can't find enough network specialists to grow their cloud business fast enough is a point in favor of not buying the stock, as I see it. They have had years to find these specialists or else train people. They are IBM.
How can it not have enough people for a mission-critical task in its major strategic initiative?
In IBM's hyper-competitive industry, I wonder if it was possible to reinvent itself once but only once - under Lou Gerstner.
Tied in with this, I am not happy that it dodged one key point and hyped its free cash flow generation unnecessarily.
#2 - Why is IBM vague on material points?
I do not put new money into stocks wherein management is actively hyping the stock, while hiding material matters. This issue came out with reference to the Q1 press release and conference call including both the prepared remarks and Q&A, as reported by Seeking Alpha.
It required one diligent analyst, Steve Milunovich, to ask - late in the Q&A - the two key points that IBM avoided clarifying. Here are his two most relevant questions and the relevant parts of the response:
Steven M. Milunovich - UBS Securities LLC
Okay. Thank you... Number two, free cash flow. You said $11 billion to $12 billion; now, [you're at] at the high end [of that range; IBM had suddenly increased its prior guidance for FCF for this year]. Is the only difference the $1.2 billion that you received in the tax rebate, or has anything else changed in your underlying view?
Martin J. Schroeter - Senior Vice President and Chief Financial Officer
...On free cash flow, I'd say it really is - I wouldn't attribute it all to the tax that we got back. I would attribute it to we're through 90 days, we've have $100-plus billion balance sheet, and when we look at the ins and outs and the efficiency of the balance sheet, we feel incrementally more positive about the realization for the year.
So in addition to the extra cash from the win on taxes, they are going to work the balance sheet harder. So, really, the extra projected FCF generation was not from operations, which is what investors care most about. It would have been better if IBM itself had volunteered that clarifying information.
More important was this other part of Mr. Milunovich's question:
And then third, do you expect any more restructuring charges this year? Are those in your guidance at all?
This is the response, provided in full because many listeners had to sit through this being spoken, almost as an IBM filibuster:
And then on restructuring, this is something where - and we tried to go through this a bit in the prepared remarks - it really is about shifting the work force from a set of skills that have value in the marketplace today to a new set of skills where we're trying and build new businesses. The minority of the charge, if you will, is for reductions in usable capacity [e.g. real estate rationalization], and most of that's outside the U.S. The bulk of this is to get new set of skills. So as we build a Watson Health business, as we build out our security practice, we're adding new skills. So we'll see.
We think about our ability to acquire skills. In many of these sectors, we will hire them as quickly as the world can create them. We hired 1,000 security experts last year and quite frankly, if world created 2,000 of the caliber and the kind of talent we needed, we would've hired 2,000. But the world creates these skills at a certain rate and we'll hire them as aggressively as we can. We have some limits in terms of how do we put them to work and where's the demand and does that all match up, but we'll hire people as aggressively as we can as we build these businesses out. We are relying on some pretty unique talents in some these businesses.
The length and breadth of the evasiveness of his response is world-class. There were only two words that really responded to Mr. Milunovich's terse question, namely "we'll see."
And those two words are a non-answer. When provided to a senior analyst, it even might be construed as something quite rude.
Mr. Schroeter went a long way to avoid answering the question to the maximum extent. And it's the most relevant question anyone asked in my opinion.
Since IBM will not deny it, I have to assume there will be more layoffs and other write-downs, charges, etc. That in turn may provide additional downside risk to the stock.
Only a company that doesn't know where it is and where it is going can say "we'll see" to this specific question and still be telling the whole truth to its investors.
As an aside, note that IBM took this question as an opportunity to complain that the world is allegedly short of (network) security talent. But - again - this is IBM. Couldn't they have acquired or trained these people years ago, if only they had known they wanted to be a cloud company where security is extremely important? Is the cloud really all that new? (No.)
The third point expands on #1 above:
IBM has made unduly slow progress toward its growth path
IBM is still moving slowly on its transformation. This is the 2016 model of an ever-shifting story of where future growth will come from. Note how slowly this limited part of the story is growing. From the press release:
First-quarter revenues from the company's strategic imperatives --- cloud, analytics and engagement --- increased 14 percent year to year (up 17 percent adjusting for currency).
Clarifying that, from the prepared remarks in the conference call:
So now, over the last 12 months, strategic imperatives delivered $30 billion in revenue which represents 37% of our total revenue.
Given how much shrinkage is going on outside of this year's strategic imperatives areas - with even global financing revenues shrinking in Q1 from $461 million to $410 million, 37% is far too low to attract new money to this stock (at least, it doesn't attract my new money). And many of the finance customers are not of investment grade, either. As we know, more or less all major parts of the company shrank. Just for convenience, from the earnings release:
Three Months Ended March 31, 2016 2015* REVENUE Cognitive Solutions $ 3,979 $ 4,047 Global Business Services 4,131 4,318 Technology Services & Cloud Platforms 8,424 8,554 Systems 1,675 2,142 Global Financing 410 461 Other 66 67 TOTAL REVENUE 18,684 19,590
This is not what I look for when in bargain-hunting mode.
A company in transition should be far beyond 37% of the way "there" to impress me as having successfully made that transition.
Now let's think about the question from Mr. Milunovich about more write-offs:
If only 37% of the revenue comes from where the company is strategically focusing, does that mean that 63% is at risk of being sold off, allowed to shrink (or will shrink via superior competition), etc.? And if so, how much shrinkage will there be?
Why put new money in now with all the uncertainties, and with cheaper stocks in various parts of the US and international markets?
Then there's this final point, which ties in to Point #1:
There may not be as much 'there' in the cloud as IBM may think
This comes from being late to the game. Amazon (NASDAQ:AMZN) Web Services is a moving target, always improving; AMZN has already announced that margins at AWS are going to go up and down as competition demands. So it's going to do its AMZN thing of charging enough to allow it to continue to grow sales, margins being secondary. That's a real and possibly permanent problem for IBM.
Importantly, as an outgrowth of AMZN's core Internet-based retailing business, AWS is more organic to AMZN than the cloud is to IBM. After all, Jeff Bezos was first a techie before anything else.
Other tough competitors are already strong in the cloud and are growing.
Why should anyone think that there's really a pot of gold for IBM once it grows further in the cloud? Just because of Watson/analytics? I doubt that sort of thing is enough.
There's another, larger issue about a cloud-based focus:
As an older guy, I have seen what might be called a forerunner of the cloud, namely client-server technology and pre-Internet distributed data processing. Meaning, "cloud-iness" may not be forever. A pendulum could again swing away from outsourced, distant storage of data to more local storage and local networking that is more secure than the cloud and accessible even if the Internet is down.
The last thing I could think of a pharmaceutical company doing is sending its proprietary information to a third party in the cloud.
If the cloud requires so much security expertise that IBM is complaining of not having enough security talent globally to be able to hire, why is the cloud so great?
So at the end of the day, I wonder if IBM is fooling itself with its current "strategic imperative." The cloud, and related data analytics, may have profit margin challenges, and the dollar size of the market may not meet expectations.
Interim summary - no obvious reason to go long IBM
I see IBM as a former wolf that changed its skin and now is a sheep that may be getting sheared. It has been paying full retail price for acquisitions such as the Weather Company. Whether this and other deals will just be more of the same old story of failed deals is to be determined. Past history given many years now of shifting strategic priorities and countless acquisitions that in the aggregate have left IBM as a shrunken force, make these latest deals problematic for me.
In addition, the refusal of IBM to give a straight answer to the question of whether more "shrinkage" charges are coming troubles me. This is not what I want to see when deciding on going back into this name.
As a caveat, IBM is a stock, and Mr. Market knows all, sees all, etc. In the fullness of time, or soon, matters can turn around. I'm not short IBM. It may do well (I hope so), and so may the market. But between being long and short this name, the Seeking Alpha computer requires an author to choose, and my bias is more to the negative here. Overall, my view is that there are too many reasons to avoid this name to overcome hope, any positive prior feelings I have had for this name, and thus it's better to just watch what happens.
Comments on some of my prior articles on IBM
This is relevant to my overall outlook on many stocks where management is promotional. So, briefly, I'll recount some things I wrote on IBM in 2013 that are relevant to my current critique.
My first article on IBM, in July 2013, was titled IBM And The Media Attempt To Obscure Its Declining Business Results. This complained about IBM and Bloomberg News:
In fact, IBM has had a poor quarter and a poor first half, but just does not want to admit it.
Here's the hype: Bloomberg.com ("BBG") headlines it this way:
IBM Raises Annual Forecast After Earnings Top Analyst Estimates
In that article, I also raised questions about the trajectory of IBM's business, as did some analysts on the Q&A. I ended by saying:
It would appear that better and less-complicated risk-reward opportunities can be found elsewhere in the investment universe.
The other point I was making in that article, which I made just this past week in articles on PepsiCo (NYSE:PEP) and J&J (NYSE:JNJ), is that many large cap/mega-cap stocks that have "performed well" the last several years have really just been proxies for the move down in Treasury bond yields. As that July article concluded, in a more complete excerpt of the conclusion:
As have so many other stocks, IBM for the past 16 years has ended up just being a proxy for the secular decline in interest rates. It now is a troubled company that feels forced to resort to obfuscating its results rather than presenting them clearly.
It is unclear that with these difficulties, IBM will do any better for investors than a Treasury security.
Increasingly, as stocks have churned since QE 3 ended, this observation is proving more and more true for more and more stocks.
Later, on Oct. 17, 2013 - I wrote IBM's Description Of Q3 Supports My Previous Bearish Articles. How Low Can The Stock Go?
The stock had closed at $186 the prior day; then earnings were released after the close, and IBM opened at $174 as that article was being submitted for publication. This seemed like a big drop, possibly excessive and IBM had lots of defenders (as always), but I thought there was more downside action to be concerned about, saying:
...IBM has retained no profits for years, I am hard-pressed to find the stock attractive to new money purchases much above one times sales per share. That would put the stock somewhere around $90.
However, I was realistic about IBM's support on the Street and continued by saying:
Of course, there is much too much support for the shares for the stock to drop such a massive amount unless operations became much worse than they have become, so I don't think that $90 is a realistic target...
I... think that somewhere between $90 and $180 is where the stock can drift or plunge down to on its own merits. Why not about half way between them?
Meaning, $135. Which is where it was indeed headed.
I think these observations back in 2013 hold up well.
To be complete, I wrote one bullish article on IBM in 2014, after some of the Street turned bearish on the stock, and actually had a brief position in it. Then I realized I was guessing on a turnaround and that biotechs had clearer upside. When IBM soon enough proved that its brave words that year had again fallen to a dimmer reality, I just ignored this name for Seeking Alpha purposes until now.
Now, one reason I'm following it again is that I wonder how much of a leading edge situation it might be for a US economy that continually is about to surge upward but never does. That leads to the final segment of this article.
Could IBM be a predictor for some of the market?
One of the clues that IBM was on a disappointing trajectory was, as stated in my linked 2013 articles, its increasing reliance on non-GAAP numbers and the eagerness of the financial media to play along with that meme. Unfortunately, this former rarity is now the norm. Gretchen Morgenson, who provided lots of warning of the 2007-9 meltdown, has this out in the NYT this weekend:
Fantasy Math Is Helping Companies Spin Losses Into Profits
According to a recent study in The Analyst's Accounting Observer, 90 percent of companies in the Standard & Poor's 500-stock index reported non-GAAP results last year, up from 72 percent in 2009.
Among 380 companies that were in existence both last year and in 2009, the study showed, non-GAAP net income was up 6.6 percent in 2015 compared with the previous year.
Under generally accepted accounting principles, net income at the same 380 companies in 2015 actually declined almost 11 percent from 2014.
Another striking fact: Thirty companies in the study generated losses under accounting rules in 2015 but magically produced profits when they did the math their own way. Most were in the energy sector, which has been devastated by plummeting oil prices, but health care companies and information technology businesses were also in this group...
But[GAAP expenses excluded from non-GAAP "earnings represent"] actual costs, notes Jack T. Ciesielski, publisher of The Analyst's Accounting Observer. "Selectively ignoring facts can lead to investor carelessness in evaluating a company's performance and lead to sloppy investment decisions," he wrote. More important, he added, when investors ignore costs related to acquisitions or stock-based compensation, they are "giving managers a free pass on their effectiveness in managing all shareholder resources."
It puzzles some accounting experts that the Securities and Exchange Commission has not been more aggressive about reining in this practice.
There are now few companies like Apple (NASDAQ:AAPL) that both report only in GAAP numbers and trade at traditionally normal P/Es that would appear to reflect the downside risks to the total return of the stock over many years.
The SPY at around $209 is trading close to 24X TTM EPS. The other 1000 companies that with the SPY comprise the S&P 1500 index are trading more richly than that. If the SPY were a stock, with both sales and EPS faltering, and with lots of leverage, I would have trouble finding it attractive on its own merits.
So, while IBM can trade anywhere, and can falter farther or fundamentally rebound - and is worth keeping track of by many investors who are out of this name - the SPY arguably should not be viewed as a Fed-sponsored entity but by its current challenged GAAP fundamentals.
Concluding thoughts on what is, and is not, attractively valued
Sometimes the best thing to do in the markets is nothing, whether it's with a stock one is following, an index, a commodity or whatever. That's how I view IBM right now. Shorting a high free cash flow stock is chancy even if one is "into" shorting, and one with as much support on the Street as IBM is even more chancy. But I rarely sell short, and simply see IBM as a security to follow but avoid taking any position in for now.
Broadly speaking, I see the SPY as a better asset right now than IBM, but at a higher valuation, thus a difficult new money buy here as well based on fundamentals.
In contrast, I continue to see a number of the larger biotechs (NASDAQ:IBB) as being well-run, having below-market P/Es but with strong balance sheets, and as having much more secular growth potential than the average public company has. It's normal, after a large multi-year run such as biotechs have had, to have a period of bear market action, but these sorts of stocks continue to strike me as representing the best longer-term bets the US stock market has to offer.
Thanks for reading. It's more fun to write bullish articles. I look forward to any comments you would care to share.
Disclosure: I am/we are long AAPL.
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.
Additional disclosure: Not investment advice. I am not an investment adviser.