Last month, IBM Corp. (NYSE:IBM) released its Q3 2015 results, and on the surface, it looked like more of the same: lower revenue for the 14th quarter in a row. However, below the surface, the transition away from hardware toward high-end consulting and services, especially in the IoT area, continues unabated. This can readily be seen when, last week, IBM announced the acquisition of weather.com (but not The Weather Channel). In my opinion, this transaction indicates the new direction more than any other acquisition the company has made. Consider this article a follow-up to an article I wrote about IBM's 1st-quarter results: "IBM: Sometimes Flat Is Good - 9 Positive Points From Q1 Conference Call".
In this article, I argue that IBM's concentration on high-end, proprietary and unique products and services will finally drive profits toward $20/share and the stock price at least 50% higher.
The techniques I developed for studying turbulence, like weather, also apply to the stock market.
Weather is everywhere, including the latest quarterly statement
When IBM reported earnings, it mentioned weather three different times, in what was a harbinger of the deal with weather.com a week later. SVP and CFO Martin Schroeter mentioned weather in terms of a contract with a "major global airline" to use "weather conditions" to "optimize fuel load". Another comment concerned a "European Hospitality Company" which is "looking at structured data such as frequency and timing of credit card purchases, combined with unstructured data including social chatter on Twitter (TWTR) and real-time weather". A third client is looking at a solution that "will combine the client's internal data with all kinds of external real-time data sources such as current weather patterns, local events and social commentary". If you think about all the applications there are for real-time weather data, it is enormous and adds to IBM's proprietary arsenal. For example, it is hard to imagine any airline not being interested in IBM's weather analytics, when you consider airlines spent over $46 billion on fuel in 2014.
IoT is a huge market for IBM's consulting and analytics service
Contrary to what some may think, chips are not going to be the big beneficiary of the rapidly expanding IoT market. It will be services, software and data analytics that generate the most profit. And in this area, IBM has some very good platforms to service almost anyone's IoT needs, including Watson, cognitive thinking, hardware encryption/decryption, managing unstructured data and using the cloud to service any company's IoT needs. As Schroeter put it "They use Watson cognitive APIs to make sense of the data. This requires a platform approach that integrates industry expertise, analytic software, cognitive APIs, cloud, Bluemix, and multiple data streams". A key phrase in that sentence is "industry expertise", something IBM, having been around for 50 years, has in spades.
IBM's cloud revenue is larger than Amazon's, and it's growing at 50% YoY
At $9.4 billion, IBM's cloud revenue includes hybrid cloud service, installation and consulting, while Amazon's (AMZN) AWS is close to 100% services. On a service basis, IBM is running at a $4.5 billion rate versus AWS at about $6 billion. But IBM's integration and consulting services for conversion from classic IT to cloud is a high-margin business that AWS will never be competitive with.
IBM has the best customer list in the world
Back in the 1960s, the company's dominance of the IT industry (it was known as "Data Processing", or DP, back then) was so complete that the phrase "IBM and the 7 dwarfs" was used to describe the industry. It was during that era that IBM acquired the largest and best-funded organizations in the world as customers, and they continue to be customers today. In other words, every large organization is familiar with the company and its capabilities, even if IBM's market share of IT spending (65% in 1965) is a fraction of what it was in the 1960s. And many, if not most, of them have been IBM customers for decades. Nations, states, cities (remember IBM's "smart city" ads on TV?) banks, insurance, airlines, universities, government agencies, etc. are all high-end sales prospects for the company's range of high-end, high-margin services. I think the value of IBM's customer list is its least understood and least appreciated asset.
Unique and proprietary products make for very high margins
The weather.com acquisition is just one example of IBM's move toward high-margin sales. There is, of course, Watson and data analytics, Bluemix for 3rd-party application development, the Power chip for high-end servers, and the Z13 mainframe, among many others. And all of these can be applied to the company's rapidly growing cloud services portfolio, in addition to providing IBM with the opportunity to sell high-margin consulting services too. I think Warren Buffett sees these proprietary products as part of the "moat" he so often talks about, and that is one of the reasons, along with share buybacks and high ROE, he continues to invest in IBM.
In this article, I have purposely avoided talking about the financial details of IBM's current quarter, since there is an abundance of that already available on SA. Instead, I wanted to concentrate on the business potential of the company's new approach. However, I will mention a couple of financial items I consider to be important.
First is the ever-increasing gross margin number, which has grown from 46% in 2010 to 49% in 2014 and to 50% this quarter. Even though that increase looks nominal, I think it shows the focus and direction the company is taking. Turning an oil tanker around is not easy.
Second is the almost $75 billion in free cash flow over the last 5 years. This company is still a cash flow machine, and at its current price of about $143, is selling at only about 10X FCF, compared to the nearest peer (sort of) Accenture (ACN) at 20X. That is a very big difference, considering ACN's gross margin is less than 30%. And ACN's P/E of over 20 is more than twice IBM's current 10X.
Next year will probably be better, but still continuing the transition at least until the 2nd half. Then, I think we will see a big acceleration in earnings in 2017 through 2019, culminating in earnings of at least $20. With a small incremental increase to 12X, we will see at least a price of $240 a share, and you get a dividend of 3.7% and a lower share count while you wait.
If you are a bit braver, you may want to try the 2018 $200 LEAPS at less than $2.
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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.