International Business Machines (NYSE:IBM) is the world's largest software services company with annual revenues of ~$104 billion. The company has a big presence in the software and hardware segments as well. The company's management has shown great foresight in the past, successfully navigating the shift from a hardware focus to a software/services focus. The company's sale of its PC division to Chinese giant Lenovo was a master stroke. While US PC companies like HP (NYSE:HPQ) and Dell (DELL) have struggled in recent times, IBM has thrived. The company's stock has outperformed the major US technology companies such as Dell, HP, Intel (NASDAQ:INTC), Cisco (NASDAQ:CSCO) and Microsoft (NASDAQ:MSFT) in the last 5 years giving a ~53% return to investors.
However, I have been bearish on IBM stock for quite some time now due to concerns about revenue and margin growth. IBM's topline has remained mostly flat over the last decade, despite a number of acquisitions. The limits of margin expansion have also been reached as the company has mostly shifted out of the low margin hardware business. I don't think that the IBM stock is a good one to own and investors should look at better alternatives. IT services companies like Cognizant Technologies (NASDAQ:CTSH), TCS (TCS.BO) and HCL Technologies have shown excellent growth and are better investments in my view.
Why you should sell IBM
1. Topline growth has stagnated - IBM's revenue stagnation has been hidden by improving margins. However, even the limits of margin expansion have been reached as IBM has exploited the advantages of outsourcing to low cost locations like India almost fully. IBM's hardware segment has also become quite small and it will be difficult to improve the margins by reducing its hardware business since it has lower margin. IBM is thinking of selling its x86 server business to Lenovo. However, that will lead to a further reduction in the topline. IBM missed on both revenues and earnings in its most recent quarterly results, as the sales declined by 5% year on year.
Revenue from technology services declined 4 percent during the quarter, to $9.6 billion, and business services revenue fell 3 percent, to $4.5 billion. Software revenue was flat at $5.6 billion, while hardware revenue dropped 17 percent to $3.1 billion.
The company showed a revenue decline in almost every geography.
In Asia-Pacific revenue was down 1%. Within that Japan revenue was up 3%. This was the second consecutive quarter of revenue growth in Japan reflecting the stabilization of our business in that country. The balance of AP, which is part of our growth markets declined. Across all geographies, our growth markets revenue was up a disappointing 1%, though five points faster than the major markets. BRICs were up 3% led by Brazil, while China and Russia posted modest declines. China's performance was impacted by weakness in large deals and a slowdown in our low-end and mid-range products.
2. Smaller competitors are doing much better - Smaller competitors like HCL, TCS and CTSH have consistently outperformed IBM in growth. Even the worst performing Indian IT service companies like INFY and WIT are showing 5-10% growth. IBM is losing market share which is not a good sign for an IBM investor. It might be a good time for IT investors to explore alternative companies like Cognizant Technologies. I believe CTSH has been amongst the best performing technology stocks over the past decade.
3. Software Services and Software Segments is getting crowded - IBM is facing increasing competition in its core services segment. The big hardware companies are seeing the revenues and profits disappear, as the technology industry undergoes a major paradigm change. "PC" companies like HP and Dell are trying to copy the IBM model of shifting the focus on software and services. These companies have bought a number of smaller software and services players to increase their competency in this space. As competition increases, it will become harder for IBM to grow, if not maintain its current level of revenues and profits.
4. Margins have hit a ceiling - The biggest reason for IBM's stock price growth has been the management's ability to consistently improve margins. Earnings have tripled in the last decade allowing IBM to buy back billions of dollars of its own stock. Management has also not been afraid to take debt to finance stock buybacks and pay dividends. However, I don't think that there is more room for margin improvement, given that the two main drivers have almost been fully exploited. The company will have to increase revenues if it wants to grow earnings.
5. Valuation is not Cheap - IBM is not cheap as it trades at a premium to average industry multiples with a P/B of 11.2x and P/S of 2.1x. The forward P/E of ~10x does not seem expensive, but that might go down as the company shows a revenue decline. IBM has been very aggressive with buybacks and dividend. This has meant that the company has taken debt to return money to shareholders. The debt to equity ratio of IBM is high for a technology company at 1.3. The company has a net debt of ~$22 billion which is quite high for a technology company with low capex requirements and large free cash flows.
IBM Upside Risk
Technology Advantage - IBM has one of the biggest R&D budgets in the industry and spends resources on developing a wide variety of products/services such as cloud computing, analytics, "Big Data" etc. The company has one of the biggest technology patent portfolios and earns substantial profits by licensing patents. IBM is present in a number of areas like solar energy, semiconductors etc. However, given IBM's huge size, the company will have to launch a number of new blockbuster products to move the needle.
IBM has done well in the past by sharply cutting costs through shedding the lower margin hardware business and outsourcing its employees to lower cost locations. However, IBM has been plagued with stagnating revenues, which has taken a turn for the worse in the current quarter. IBM manages to meet and exceed earnings almost every quarter, so this quarter's miss was a shock for investors. IBM fell by more than 8% which is quite high for IBM's low volatility stock. I have been warning that IBM stock is expensive given the company's revenue trajectory. While I would not advocate shorting IBM's stock, investors should definitely look at putting their money in better companies. TCS and CTSH are two excellent companies that investors can consider. They have very good management and are showing high double-digit growth.
Disclosure: I 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.