IBM: Another quarter and lots more explaining to do
IBM (NYSE:IBM) reported its Q2 results after the market closed July 18. After attempting a rally, the shares have given up their gain and declined a bit at this writing. And to me, that makes sense. So far, little has changed for the better and there are some withered shoots that stick out. Ok, if one looks at the headlines, they consist of a report that IBM beat on EPS and beat on revenue. Well, if those are the headlines, then it must be so. Not really and from the vantage of this observer, the results of the quarter might be said most fairly to be "in-line" with some disturbing trends. The most disturbing trend in the quarter would be the continued decline in the growth of the "strategic imperatives" component of IBM revenues. Now 38% of total IBM revenues, strategic imperatives grew at a 12% rate this quarter, a growth rate that has declined now for over a year.
Before embarking on a deep dive into what has happened, let me post a mea culpa here. I first wrote an article for Seeking Alpha regarding IBM on January 26th and titled it 'Far Less Than Meets The Eye'. The title was fine - the share price expectation - well not so much. The shares were $122/share on that date and look to be just shy of $160 in afterhours trading. The IGV software tech index is up 16% from 1/26, so IBM shares have racked up lots of positive alpha. IBM shares have appreciated by a third since making a low in the midst of the tech panic.
In a value or dividend portfolio, that is fantastic performance, and a performance I would have totally missed - and have missed in my own portfolio. It really doesn't matter much if you are right on expectations but the share price doesn't agree. In Latin, the saying is de gustibus non disputandum est. It was never meant to refer to share price expectations versus results, but it will have to serve duty in this case. Knowing what people want from their investments can be just as important as knowing what results people's investments are going to achieve. If investors, analysts and readers are satisfied with IBM's results, then it is bootless to argue with their conclusion. But bootless or not, I will at least go through the analysis of what is happening up in Armonk and wonder just how long this magician can achieve the desired objectives.
I have little doubt that articles from both SA contributors and from analysts will be festooned in whole or in part with headlines to the effect that the transition is continuing. Those articles will, in my opinion, sadly beg the questions as to what is meant by a turnaround or a continuing transition. Another saying here, the devil is in the details except these details are really not hard to find and more or less leap from the dry pages of the earnings release.
The case of the steadily disappearing strategic initiatives growth rate.
Before diving in full bore, I will finish this introductory section with one set of statistics. IBM's strategic initiatives growth has shown quarter after quarter of declining percentage improvement. That really is not any way to run a turnaround or a transition. Last quarter's growth rate in strategic imperatives was 12% year on year (no difference because of currency in Q2). The growth in Q1 was 17% in constant currency, the growth in Q4-2015 was 17% in constant currencies, and the growth in all of 2015 in constant currency for strategic imperatives was 26%.
The company's CFO was asked about the reasons for this disturbing trend and I commend the man for his attempt to explain the inexplicable. (And I realize that those are valuable words - but what else is there to say - that the trend is not disturbing.) Mr. Schroeter is articulate and intelligent, but that particular question stumped him. He decided that the best answer would be to comment that IBM's strategic imperative initiatives are ahead of some longer-term revenue objective and to leave the issue of declining percentage growth rates to another quarter.
He commented that strategic imperatives was already 38% of revenue compared to an aspirational goal of 40%. Needless to say, that can happen one of two ways. One way would be for strategic imperatives to show strong growth and the other way would be for the core or the legacy business to contract. No prizes for guessing what has actually happened. Politicians do those kinds of things frequently, CFOs really shouldn't.
As I will discuss later, some of the results in strategic imperatives were woeful and some were less so, and perhaps indicative of a green shoot or two. Those that were abysmal were those not buoyed by acquisitions to a greater or lesser degree. Strategic imperatives is still not the trail out of the wilderness of the Sinai into the land flowing with milk and honey. In fact, in the view of this writer, it represents one of those traps in terms of cognition often written about in both the pages of history and the pages of investing.
Reports of IBM's demise are greatly exaggerated; reports of IBM's struggles are not
IBM reported non-GAAP EPS of $$2.95 which was 2% above prior consensus expectations. Revenue for the quarter was $20.24 billion or about 1% above the prior consensus. Company guidance for the balance of the year was unchanged. Multitudes cheer and shout hosannas! IBM isn't dead. I certainly do not expect it to die. I also do not expect that it will grow and thrive, at least as it is presently constituted.
There should be no doubt that transitions are hard to implement, and harder still when a company has to play catch-up simply to stay in the same place. A transition that has to be undergirded by making 20 acquisitions a year has to be one of the more challenging strategies that has ever been pursued by a large, somewhat sclerotic company. And yet, when queried about the strategy, Mr. Schroeter replied that IBM is about acquisitions. And so it must be, simply looking at the data in the earnings report.
But trying to acquire and digest and optimize 20 companies a year is a feat I doubt that many companies could pull it off, and yet for IBM, it is basically a necessity. If 20 acquisitions are necessary to keep the company's revenue at almost break-even levels, then I think the risk/rewards for IBM shares going forward are rated toward losing alpha. No demise, but certainly no hosannas either!
It should be noted that the sum of many acquisitions (17 in the last year according to Wiki) contributed about 200-300 bps to revenue in this past quarter. That positive tailwind will decrease and disappear during the first half of 2017 - although perhaps it might be replaced by other acquisitions. In fact, CEO Martin Schroeter said that acquisitions are part of IBM and need to happen. Indeed, one questioner on the call asked Mr. Schroeter why it was, that adjusted for the rising contribution from acquisitions, the revenue decline at IBM actually accelerated last quarter, particularly, it seems, in the software space.
Mr. Schroeter is, no doubt, a capable and an articulate CFO of a large institution. He has spent his entire working career at IBM, and that is not likely to have suited him well in terms of objectivity. It has suited him, in terms of understanding the nuances of spin. But that question - well all Mr. Schroeter could do was to say that acquisitions were part of IBM and by implication were necessary for its growth.
Most of or perhaps all of the earnings beat was a function of higher levels of IP licensing and of gains in other income. Yes, they do count, but the fact is that they tend to be cyclical, and by their nature are not recurring.
IP and development income almost trebled year on year and reached $400 million last quarter and was up from $140 million in the 2015 period. After taxes, it appears that the increase in royalty revenues increased net income by about $.025 per share which was half of the reported earnings beat. The performance of royalty revenues is more or less random and is highly unlikely to be repeated in subsequent quarters. The balance of the beat came from another random source, other income. On an operating basis, IBM had no beat.
From an operating perspective, the best achievement that IBM reported actually was in new services signings which rose 16%. Services signings have been weak for basically years and services, overall, remain one of the company's largest revenue buckets. Interestingly, despite the 16% growth in signings, backlog in services was just flat. Is 16% one of the potential green shoots about which I wrote. Based on Mr. Schroeter's response to a series of questions on the subject, it would seem he isn't quite sure. But it was an unqualified attainment nonetheless, and the most unqualified attainment of the last quarter in my opinion.
Despite what follows in this article, the strength in services signings is probably of a magnitude that will allow IBM to achieve its 2H forecast, although its implied Q4 estimate is clearly a stretch given what visibility outsiders have at this point.
One commentator suggested that revenue contraction of 3% is a feat. It isn't, when the foundation of the "attainment" is built heavily on a massive level of acquisitions. IBM is indeed in the midst of a transition and 38% of its revenues do come from strategic imperatives - but how well is IBM really doing in strategic imperatives.
I have, in the past, wrote at some length in trying to assess IBM's competitive positioning in the various buckets that compose strategic initiatives. There is no great reason to think that the conclusions I reached in January would be any different now. With the possible exception of Watson, and IBM's apparent strength in AI, its competitive position within its other strategic imperatives buckets is tendentious at best and at some level ought to be a cause for alarm on the part of those observers who are convinced of the company's future prosperity.
If the growth rate of strategic imperatives declines steadily as it has, might someone ask the question as to why that might be happening? If IBM reports a 30% growth in the cloud, and other competitors in the space are reporting growth that is double or more, is that grounds for optimism?
Microsoft (NASDAQ:MSFT) reported its numbers a few hours ago. Its cloud product, Azure, showed 108% growth and that was organic. Oracle's (NASDAQ:ORCL) cloud revenues grew more than 50%. In that context, is 30% growth an achievement or a disappointment? In following IT for many years, market share is one of my Gods. Losing market share - and that is what 30% growth represents, is an issue that is hard to explain.
If strategic imperatives grew by 12% during the quarter, doesn't that suggest that the 62% of the business that isn't strategic must have contracted by more than 12% to achieve a top line result that showed a 3% contraction. How many quarters would it take for strategic initiatives growth of 3% to overtake the decline in the legacy businesses of IBM? Is that the nature of the transition?
I don't want to suggest that there were no bright spots for IBM, but if the company's name was 3 different letters, most observers would focus on things that were issues. Within strategic imperatives, the largest single bucket is analytics, which at $4.9 billion of quarterly revenue is 59% of the total and which grew by 4%. That is actually somewhat better growth than Q1 growth - but how much of that was acquisition and how much of it was organic?
Last fall, IBM announced that it would acquire the Weather Company (other than its broadcast operations) primarily to obtain its IP and to use that IP to create cognitive solutions and analytics outside of forecasting the weather. The terms have never been disclosed but the consideration has been rumored to be in the $3 billion range. As part of the transaction, IBM switched Weather's big data platform to the IBM cloud.
People like myself naturally wonder just how much of IBM's growth, both overall, but specifically in the cloud is a result of transactions such as this, of which there have been more than a few in the past several quarters. Should the transaction as described be called barter? I will let readers be the judge, but the facts of the case are self-evident. IBM acquired a company, the acquisition switched a major cost component to an IBM service and IBM got to report of the service in cloud growth.
I do not believe that Azure's 108% growth rate had anything to do with barter-type transactions. I do think that the growth in demand for pure cloud on a percentage basis is greater than the growth in demand for hybrid solutions (what IBM sells).
Weather sells its services to a huge number of mobile customers. How much of the strong mobile performance that IBM reported in strategic imperatives (growth of 43% to a revenue total of $1 billion for the quarter) comes from this and other acquisitions and how much of the performance has been or is organic. (I have no idea just how much revenue IBM acquired when it bought Weather. It did not buy the TV station but signed a long-term license agreement to provide it with the forecasts that power its broadcasts. I have no idea as to the terms of that agreement. If I were a great believer in conspiracy theories my guesses would be that the entire transaction smacked of a fair amount of barter designed to enhance optics. Sadly, that is hard from infrequent in the enterprise software world although it isn't supposed to happen.)
Spoil Sport or Realist?
Is this kind of analysis being a spoil sport? I do not think so. In my mind, IBM's transition, if and when it happens, has to be built on not just revenue growth in some highly selected product categories but on a transformation that allows the company to sell the technology it develops and acquires and to sustain or better yet gain market share. Any other kind of "transition" will prove chimerical. And there was simply nothing in the reported numbers for this past quarter to prove that such a transition is underway or that it will soon become visible.
There are more than a few observers who will jib at such seeming heresy. But I think it isn't heresy but just numbers.
One example of what I mean. Over time, the cloud will cease to be an overall driver of IT spend growth. Not because something has come to replace the cloud but simply because as the cloud becomes the standard compute platform for most workloads, it simply can't grow much faster than the growth in overall IT spending and that is no better than low-single digits. How might IBM's growth perspective look in an environment in which growth in the cloud was declining and IBM's share of cloud revenues was also declining? It is hard to make the case that IBM's share of total cloud revenues isn't declining given the results it printed and the results printed by its major rivals. When cloud growth rates start to flatten, it doesn't really bear considering what that impact will be on a company like IBM that is losing market share.
Transitions can be about making investments in product areas that are growing but they also need to encompass company cultures and so far there are no signs of that at all at IBM. If IBM has evolved into a nimbler organization with more aggressive go-to-market strategies, the visible impact is hard to find. I think that the headlines concerning Watson have been such as to lead to a kind of self-mesmerism in which most analysts and investors had felt that if nothing else, analytics might be a growth driver. At least, based on the results of the current quarter, that appears to be more than a bit unlikely.
I am actually surprised that Watson has not generated more analytics revenue than appears to be the case. AI ought to be one of the really "really big things" in computing for the next couple of decades and by all accounts, Watson technology is at the forefront of developments in the field. Whether Watson can be monetized such that it will really carry the rest of the enterprise is tendentious and not readily answerable. But the numbers that were reported are not those that would necessarily give one a huge amount of optimism on the subject.
Cloud, mobile and security showed substantial double-digit growth rates. The questions that arise are how much of the growth is organic and how much is the product of acquisition and how does IBM's growth compare to the growth of other direct competitors. I think that it must be said, to a greater or lesser extent, that commentators who are unwilling to address those questions have prejudged the matter and really do not care to provide impartial advice but are simply …whatever comes to mind here is not appropriate in this kind of article.
Overall, in the past 6 months, IBM has spent $5.4 billion on acquisitions. That is obviously greater than the $4.5 billion that the company generated in terms of free cash. But here is a conundrum that is not readily solvable. If IBM has to spend billions of dollars on acquisitions simply to stay in the same place, more or less, and spending that much consumes all of the free cash flow and more, than how does IBM continue down that path indefinitely? Is it coincidence or something else that has created a vacuum in acquisitions the past 100 days? I am sure if a great acquisition, as judged by IBM management was available, the resources would be marshaled to make the acquisition happen. But are there enough decent if not fantastic acquisitions available at a reasonable price, that given the company's financial constraints are adequate to keep the machine running on all cylinders?
Overall, IBM generated $4.5 billion of free cash, it invested $5.4 billion in acquisitions, and it returned $4.4 billion to its shareholders. Is that prudent capital allocation? Of course, given IBM's balance sheet which has a current cash balance of $10.6 billion, it can go forward on that course for some time. But many investors own IBM shares because of the company's known policy of raising its dividends. Can that policy continue simultaneously with both share repurchase and acquisition strategies? And if acquisition strategies are the area to be compressed, how will that impact IBM's growth rate going forward?
Some shorter-term considerations
IBM presents a series of slides to go along with its conference call and its earnings release. They are worth looking at and pondering. Mr. Schroeter has drawn a very firm line in the sand about what will probably happen the next two quarters on slide 12 of the presentation.
So far this year, IBM has reported non-GAAP EPS of $5.30 and that is down 21% from the prior year. Mr. Schroeter has forecast that EPS for Q3 will be $3.24, and so EPS in Q4 would have to be just shy of $5.00. That would actually show growth for Q4 for the first time in several years.
Mr. Schroeter's reasoning, trying to summarize his chart, is as follows:
- More contribution from layoffs in the 2nd half;
- Less impact from the decline in mainframe revenues;
- Lower investments (spending) in cognitive and cloud areas;
- Lower impact from dilution from acquisitions on EPS;
- Stronger impact from the ramp up of what management calls annuity software revenues; and
- Currency expected to have less impact.
I am a bit hard put to understand chart 16 which depicts the impact of currency on IBM's reported revenue. It says that IBM saw no currency impact in Q2 from currency. The current spot rates are such that currency is supposed to have no impact on IBM for the full year. I am not sure how that forecast relates to item "f" above.
Mr. Schroder essentially suggested that there would be no impact from Brexit, even within the UK. That there was no impact in Q2 is not hugely surprising. It would be difficult to imagine that there will not be some impact during the balance of the year. SAP's (NYSE:SAP) impending earnings release might - or might not - shed some more light on that topic.
Most of these items are within the control of or are known to IBM management. None of them really seem to relate to the state of the business going forward. IBM has proven that it knows how to and is adept at managing its costs. While forecasting EPS of almost $5 for Q4 seems a bit bold, given the visibility the company has due to a high level of services contract signings it achieved last quarter, it could happen.
But unless IBM can show that it is reversing its continuing decline in year-over-year revenue comparisons and that it is at least stabilizing its market share performance, it will mean very little to me and perhaps to other potential investors or stake holders. An accelerating level of revenue contraction is not normally considered a positive indication in the midst of a transition. That is what happened this past quarter - nothing more and nothing less.
Looking at cash flow and operating earnings
Many readers may find looking at the details of the company's cash flow and earnings performance a boring analysis. It isn't that the results are not well known or particularly ambiguous - it is the explanations of the results that are controversial. Sometimes Jim Cramer does a great job in synthesizing the chatter. This is one of those times, I believe Mr. Cramer does a great job of making the boring entertaining.
Sadly, I lack that gift There is very little I can do to make this section a great read - other than to keep it as short as possible.
Gross margins declined across the board with the exception of systems where gross margins were flat. The decline in gross margins in Q2 was 200bps in total on a GAAP basis. Gross margins fell the most in the Cognitive Solutions which is probably not the statistic most appealing to IBM bulls.
SG&A expense increased by 3% year on year, and was 26% of revenues compared to 25% of revenues in Q2-2015. R&D expense increased by more than 10% year on year and was 7.2% of revenue, up from 6.2% of revenues in the 2015 quarter. IBM's effective tax rate for the quarter was 140 bps greater than it was in 2015.
IBM's software revenue continued to swing from transactional to annuity based. Overall, software transactional revenues declined 15% while annuity software revenues grew by 7%. At this point, annuity software revenues are significantly greater than what IBM calls transactional revenues, so that the 7% gain in annuity software revenues led to a 1% overall gain in software revenue. But if one took the trouble to look at all of the components of IBM's software revenue, it would become apparent that for the most part they are losing marketshare and suffering competitive displacements.
Cash flow declined in Q2 primarily as a function of the decline in net income. CFO Martin Schroeter reiterated his view that free cash flow expectations have remained unchanged for the full year. Put into more specific terms, IBM expects the conversion of net income into free cash flow will be in the high 90% range. So, if IBM does wind up earning $13.50 share, its free cash flow ought to be close to $13 billion. That would suggest that the next two quarters will see significant improvement in free cash flow generation. Again. The forecast for free cash flow is essentially equivalent to the levels that have been generated in the past 12 months.
Free cash flow was $2.1 billion last quarter down from $3.4 billion in the prior year quarter and free cash flow for 6 months was $4.426 billion compared to $4.450 billion. Both earnings and free cash flow will be substantially back-end loaded, should IBM achieve its current forecast. IBM currently has $10.6 billion of cash and marketable securities and total debt of $44.5 billion. Excluding the global financing debt, IBM has $18 billion of debt and the debt to capital ratio has increased to 59%.
While IBM is very dependent on acquisitions for growth and its future product positioning, overall, it seems likely that at least in the very short term, the company's acquisition pace has slowed and may continue to slow as it tries to digest all the businesses that it has purchased both operationally and financially. That would doubtless help both current EPS and cash flow generation at the expense of future growth.
- IBM's Q2 earnings release apparently changed the minds of few analysts or investors. Some saw it as positive, and others were troubled by ambiguities and downright disappointments.
- IBM shares have been great performers since the start of February, rising by 30% over that time and far outpacing averages. There has been little in the way of operational performance to account for the share price appreciation, but many investors seem pleased with what it is that IBM has reported.
- The growth of IBM's strategic initiatives has continued a decline of long standing.
- The contraction of IBM revenues accelerated on an organic basis this past quarter.
- IBM operating margins declined in all but one reporting segment last quarter.
- IBM's free cash flow declined year on year in Q2.
- The sum of IBM's capital return program and its acquisitions is significantly greater on a trailing 12-month basis than is its generation of free cash flow.
- Management emphatically reaffirmed guidance for both free cash flow and EPS for the balance of the year setting a very strong expectation for Q4 results.
I deliberately didn't focus on specific valuation metrics in this article. I think valuation metrics mean little if a company's earnings and revenues are shrinking, and it makes comparisons with peer companies more than a bit fraught. But given the trends, IBM shares are hardly cheap. I have been more than wrong thus far but it seems to me that the case for positive alpha loses more and more of its "beef" with each quarterly earnings release.
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.