Over the past few years, IBM (NYSE:IBM) has consistently disappointed investors, and despite a relief rally over the last few months, things at Big Blue still don't appear to be getting any better.
On the one hand, transformations and turnarounds take time, and it shouldn't really be a surprise to anyone that IBM has yet to return to strong growth (without the help of buybacks). On the other hand, at this point, the bullish angle on the stock is getting harder to support. As I discussed earlier this year, Buffett's thesis on IBM's brand power has been proven wrong, and results over the last few quarters suggest to me that IBM has a long way to go before it turns the corner (if it ever does.)
There are three specific issues that stand out to me as worth watching for prospective investors.
Issue 1: Strategic Revenues Still Not Offsetting Declines
Everyone knows that a lot of IBM's revenues in legacy areas like middleware, mainframes and so on are going to decline, and there's really not much the company can do about that. The bull thesis is essentially that at some point, "strategic imperatives" revenue related to buzzwordy areas like Big Data and Cloud will more than offset the declines in legacy revenues and allow the company to return to revenue growth (or at least keep revenues flat).
The challenge, unfortunately, is that while strategic revenues are rapidly ramping up, they have yet to come close to offsetting declines in the legacy business. In the trailing twelve months, strategic imperatives are up to $30 billion in revenue, or 37% of total - up nearly 3x (on a percentage of total revenue basis) since half a decade ago. Yet this still doesn't seem to be making a dent in consolidated revenue. Organic constant-currency revenue growth for IBM was still roughly negative three percent in the quarter, and acquisitions (on which IBM has spent a whopping $9 billion over the trailing twelve months) are only expected to add a point or two of revenue growth on top of that.
Issue 2: The Transformation To Nowhere
The second major whopper in IBM's earnings was news that they're spending more than a billion dollars to continue to transform their workforce. While this will be fully funded by a tax refund, and as such is not particularly material to near term cash flow, it's still very confusing from a qualitative perspective. "Transformation" has been the plan du jour at IBM for pretty much ever, and yet, as discussed above, shareholders are still waiting to see tangible, bankable proof.
In fact, the Investor Day transcript from 2014 - i.e., two years ago - contains the word "transform" no fewer than 26 times (according to my research tool). They have been very busy transforming for quite a while now, and yet they apparently still need to "transform our workforce and shift our skills base to new areas." Well then, what exactly was IBM doing for the past half a decade, if not transforming their workforce and shifting the skills base to new areas?
Issue 3: No Clear Path To A Better Future
Perhaps the most concerning bit of IBM's earnings release were two complete non-answers toward the end of the conference call (transcript here on Seeking Alpha). The RBC analyst asked about the savings from the transformation - which CFO Martin Schroeter clarified were essentially all going to be reinvested into new areas. Fair enough - IBM generates plenty of cash but what it needs is revenue growth.
Unfortunately, the very last question on the call - from the BofA analyst - was an opportunity for management to lay out the expected results of those investments. (At $2 billion, that's a not-insignificant amount of capital being redeployed annually.) Management did not provide any sort of quantitative help here - it sounds like these investments are necessary merely to continue the status quo (rather than drive anything better). Whether or not it results in higher growth in strategic areas, in the meantime, this significant resource drain away from legacy segments certainly isn't going to help arrest the rate of revenue decline there.
The Bottom Line
At the current price around ~$149, IBM is trading at ~11x this year's consensus EPS and still over 10x next year's. In light of continued declines in the business, the debt on the balance sheet, and no clear path to that turning around, it's hard to justify a higher multiple. IBM is still very much a "show-me" story, and right now, they aren't showing investors anything good.
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.