IBM: Will I Ever Make Any Money?

| About: International Business (IBM)

Summary

The company was an early entrant into the Artificial Intelligence race, and has devoted substantial resources to the area.

Growth in this line of business will be reflected in the Cognitive Solutions Segment.

The article discusses the growth rate in Cognitive Solutions that will be required to drive overall results and restore revenue and profit growth.

IBM (NYSE:IBM) has a lot of moving parts, and a vociferous crowd of critics. In the process of analysis, it's easy to be overwhelmed by complexity, or sidetracked into refuting mindless attacks by the ill-informed. In the interest of simplicity, this article focuses on hard evidence of the company's progress in exploiting the developing market for Artificial Intelligence, Machine Learning, or Cognitive Computing.

The quarterly and annual financial results provide segment information, to include year-over-year revenue growth and pre-tax margins. Looking at 2Q 2016, Cognitive Solutions at 4.4% is the only segment showing growth, and at 27.5% the second highest (after Global Financing) in pre-tax margins.

Here is the relevant information, from the 2Q 2016 10-Q:

Click to enlarge

A Generic Projection

The simplest way of doing a projection is to take current trends and extend them into the future, while bearing in mind that the odds of being correct diminish rapidly as the time period is increased.

Working with the data shown, I did a generic projection, assuming that margins and growth rates remain constant, quarterly figures can be annualized on a ratio that brings EPS in at $12.33 for 2016, and buybacks continue at a rate of 2.6% of shares outstanding.

After considering the current dividend yield of 3.62%, an investor under this scenario has a realistic expectation of receiving a total return of 4% for the next year, and 9% thereafter. Not bad in a market where 6% a year is the most likely long-term result.

Changing One Key Assumption

Artificial Intelligence is being hyped as the next big thing in technology. If we assume higher growth rates for IBM's Cognitive Solutions Segment, the future quickly takes on a rosy glow. At 7%, a buy and hold investor could look for 10% to 11% annualized return. At 10%, the first year would be 18%, with 13% per year thereafter.

A while ago I did an article highlighting the theoretical consequences for IBM of a possible $2 trillion market for decision-making support in the form of Artificial Intelligence.

The point is, that if IBM gets its share of this market, growth will exceed both the 7% and 10% hypothetical rates discussed above.

Credibility Testing and Risk/Reward

The $2 trillion number is too big, on a simple common sense basis. But it does demonstrate that IBM's future share price has a large but indefinite and uncertain upside, which the market is disregarding.

A long-term continuation of current mediocre results would give an investor slightly above market returns, at a beta of 0.93. So the downside risk is tolerable, while the upside potential is large, if indistinct. It can't be accurately quantified.

When the company reports earnings, the first thing I will look at is Cognitive Systems growth and margins. Those are the key numbers.

Strategy

I'm long, by means of deep in the money LEAPS, to expire in January 2018. I haven't sold any covered calls, and don't intend to, since I believe shares are undervalued.

The downside risk is defined and limited by the strike of the calls owned, while the upside is unlimited and levered at approximately 5:1. This strategy is speculative in nature.

I've been in this trade since the shares were in the $180 area, with unrealized losses that I regard as manageable. I regard the stock as a suitable investment for buy and hold or dividend growth investors who have a contrarian streak.

Disclosure: I am/we are long IBM.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.