IBM, Intel Earnings Previews: Dying Slow, Painful Death Or Business Model Transformation ?

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Summary

IBM is closer to transforming business model than Intel.

"Strategic Imperatives" - 30% of IBM's total rev's - is seeing slowing growth (not good).

Simply, IBM needs to start growing again. Cash flow has stabilized which is a plus.

Intel and the capex issue continues to weigh on the stock.

Intel cant seem to shake the dependence on the PC business.

IBM (NYSE:IBM), the mainstream technology giant that has had to reinvent itself several times over the last 35 years, from the 1980's "big-iron" moniker, to today's services giant, reports their calendar Q1 '16 financial results after the bell tonight, Monday, April 18, 2016.

For IBM tonight, Street consensus is expecting $2.09 in earnings per share (EPS) on $18.28 billion in revenue for expected year-over-year (y/y) growth of +2% in EPS, on a 7% decline in revenue.

Current expectations for Q2 '16 (think guidance) shows that Street consensus has modeled $3.45 in earnings per share on $19.8 billion in revenue, for a 10% y/y decline in EPS on 5% y/y decline in revenue.

For full-year 2016, the Street is expecting $13.55 in earnings per share on $78.2 billion in revenue for expected declines of 9% and 4% respectively for this calendar year.

That is the math - so what's the color on the numbers ?

Since IBM reported their Q4 '15 in the middle of the sharp sell-off in the first 6 weeks of calendar '16, (the worst start to any year in terms of the equity markets ever), the stock has traded up from $118 - $120, to $150 on both the rally in the SP 500, technology in general, and the timely upgrade of IBM's by Morgan Stanley analyst Katy Huberty. Huberty's upgrade also coincided with the $2.6 billion Truven acquisition, and a number of small bolt-on acquisitions IBM made in February '16 such as Resilent Systems and a couple of strategic partnerships with VMWare and GitHub, none of which I am really personally familiar with. (Here is a favorable WSJ "Heard on the Street" column that ran in mid-February '16 roughly at the time of the Morgan Stanley upgrade talking about the changes at IBM.)

While the stock has rallied sharply the last 2 months, my biggest concern is that the "Strategic Imperatives" initiative, which was the Cloud-based, "wave of the future" type longer-term investment that was going to stabilize IBM's revenue and EPS declines, actually saw slower growth in Q4 '15, down to 16% from the previous 30% growth rates.

In addition, IBM's Software segment which is roughly 30% of revenue, has seen negative y/y revenue growth for at least 8 straight quarters, and last quarter was down 2% y/y, better, but still negative.

The positives for IBM is that the y/y declines are getting less negative, the weaker dollar will help, and cash-flow and free-cash-flow growth has actually been mildly positive the last 4 - 5 quarters, which probably demonstrates the impact on currency on the income statement better than any commentary.

The bottom line is IBM needs to return to positive growth, for the stock to move higher permanently and there does remain a big question mark about when and how that will happen.

Valuation: Given the current forward EPS and revenue estimates IBM is likely fairly valued at $150 per share, trading at 11(x) forward earnings for negative "expected" growth in 2016 and a return to growth in 2017 and 2018. IBM's cash-flow valuation is 7(x) cash-flow and 10(x) free-cash-flow as of the December '15 quarter, with a $5.20 dividend and a 3.4% dividend yield. IBM boosted their quarterly dividend from $1.05 to the current $1.30 last year, and another dividend boost is at hand. The previous increase was from $0.95 to $1.05 per quarter, so a small percentage increase might be at hand as the company works through the transition.

Technical analysis: IBM is trading above its 200-day moving average for the first time since last summer and before that it was 2014. A drop back into the $140 area on light volume would be a good place to add to the stock. A trade through $140 on heavy volume, could mean a re-test of the $118 low this Q1 '16. That wouldn't be good.

Conclusion: While investors have become very frustrated with the decline in IBM from $215 in mid-2013, to $120 with the last earnings report, the timely Morgan Stanley upgrade might have put a bottom in the shares. For me, I need to see some "currency-neutral" revenue and earnings growth from IBM to induce me to add to the current 2% - 2.5% position which has been held in client accounts for years.

What will be particularly critical tonight for investors in my opinion is Strategic Imperatives growth rate and the Software segment's growth rate, as well as currency neutral revenue growth. The dollar should start to have a diminished impact on IBM's results.

If IBM's 2016 EPS and revenue declines can moderate and start to reflect low-single-digit positive growth

Investors need to gain some kind of confidence that IBM can grow again.

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Intel (NASDAQ:INTC) reports their Q1 '16 financial results the bell on Tuesday, April 19th, 2016.

Street consensus is expecting $0.47 in earnings per share on $13.8 billion in revenue for expected y/y growth of 15% and 8% respectively.

That is decent growth in this stock market.

Full-year 2016 estimates are expecting $2.35 in earnings on $53.8 billion in revenue which is 1% expected earnings growth on 5% revenue growth, which tells me that - despite decent Q1 '16 growth - expectations are tempered for the rest of the year.

One of the frustrations with owning INTC's stock over the years, is that - try as they might - the business model is still anchored to the PC business. The stock ran from the low $20's to the high $30's in 2014 all driven by positive comments from the Windows Vista refresh to Microsoft 7, and then faded after that uptick in PC growth faded.

Intel's "Data Center" segment has risen from 20% of Intel's total revenue to 29% as of Q4 '15, while as a percentage of operating income Data Center has varied from 40% to 60% of Intel's total.

It is still the PC Client Group where Intel gets its "earnings delta" in terms of really driving the stock price, so with Gartner Group coming out and saying PC "growth" fell 10% in Q1 '16, the expectations for the segment are likely subdued.

Over the years though my biggest worry has been Intel's annual "capex" load, which is roughly 40% of Intel's revenue. I've compared it to running a marathon or triathlon with a piano on your back, as was detailed in Seeking Alpha articles here, and here.

Here was an article written comparing Intel to Texas Instruments. The "Texan" started going fabless last decade which reduced that cash-flow drag and it showed up in their results, but TXN also had the end markets for it, as I've learned over time. Intel's incredible dominance and strength in the 1980's and 1990's as the low-cost microprocessor manufacturer for the PC sector became an Achilles Heel when PC growth became a replacement market and slowed significantly.

Intel Valuation: Trading at 14(x) 2016's expected earnings with an expected 5% earnings per share growth rate the next three years on a 5% expected revenue run rate, Intel is mired in this slow growth, no growth PC world.

Management has made a lot of noise about being a provider of drone chips and other processors to the ever-evolving world technology gadgets, but - like mobile chips - Intel's core competitive advantage still resides in PC's.

Trading at 8(x) cash-flow and 13(x) free-cash-flow, INTC in neither cheap nor rich. Intel's $1.04 annual 2016 dividend results in a current 3.3% dividend yield, and the company has done a better job managing insider selling in terms of stock options, although Q4 '15 saw the ISO (incentive stock options) absorb nearly 1/3rd of the quarterly share repurchase to avoid the dilution.

Conclusion: Intel's capex requirement has caused some issues with the company outside of Intel just not growing very much, particularly in the dividend and return-of-capital aspects of Intel and how they treat shareholders. I've beaten the topic into a coma, but that is what is required since capex impacts cash-flow and free-cash-flow.

I'm very frustrated with the stock and I've heard for the last 15 years about this latest transition or this newest chip is going to restore Intel's revenue and earnings growth, and it hasn't happened - only when we see a surge in PC sales, does Intel see revenue or EPS surge.

Article Summary: Comparing IBM and Intel

  • Both IBM and Intel are "old-school" tech giants that essentially have to completely re-align their business models to emerging secular trends within Technology, the most prominent of which is the Cloud.
  • IBM has been through far more critical transitions simply because the company has been around longer. Intel is finding out how tough it is to grow when your strategic competitive advantage becomes a competitive weakness.
  • IBM spends 25% of their operating cash-flow on "capex", while Intel's spends 40% - 45%. Intel's business has a far higher degree of operating leverage than IBM's, since Intel is primarily a manufacturing business, while IBM is a service business.
  • Both stocks are reasonably-valued albeit with no growth. Trading at 7(x) - 8(x) cash flow with good dividends, IBM is in a better position to generate shareholder-friendly, return-of-capital decisions simply because of the lower capex. IBM's dividend as a % of free-cash-flow is roughly low to mid 30% range while INTC''s is mid to high 30% range. IBM has - for the last few years - spent less dollar repurchasing shares sold from ISO's, from which readers can conclude IBM is making better use of the share repurchase program.
  • While Intel's Data Center Group (DCG) is their emerging growth technology segment, for IBM is their "Strategic Imperatives Segment. This is likely where the future lies with both companies but eventually both segments need to move the needle in terms of total revenue and EPS.

This article is in no way a call or tonight's IBM earnings or tomorrow's Intel earnings call, although I am biased to IBM at this point simply because of their business model and the transitions they have had to make over the years, Big Blue should be able to navigate this latest transition and drive growth at Strategic Imperatives.

My impression of Intel is that they remain stuck within the core PC competency, and I'm growing frustrated with the long position in the stock.

As the old saying goes, "gun-to-the-head", if I had to buy just one of the two stocks to hold between now and year-end, it would be IBM.

Disclosure: I am/we are long IBM, INTC.

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.