I have been a steadfast bear on tech relic IBM (NYSE:IBM) for years now. The company's epic streak of declining revenue is something I've never personally seen before and as I've lamented in the past, management teams going back 10 or 15 years have seemingly been unable to do anything other than buy back stock in a fruitless attempt to juice EPS. The lack of attention to detail to the actual business has taken its toll and for that reason, IBM was a very easy short for quite a long time. But since the stock bottomed in February it has rocketed higher from roughly $115 to its current, post-earnings price of about $163. That's an unbelievable rally and while I don't think $115 is the right price, I certainly don't think $163 is either.
Why have I been bearish on IBM for all this time? The principal reason is actually quite simple and I can sum it up with just one chart:
Source: Simply Wall St.
This is IBM's revenue since 2010 and you can see around the end of 2011 it all started to go wrong. IBM has continuously posted lower and lower revenue since that time while management twiddled its thumbs and just kept buying back stock. The results have been disastrous and until IBM finds a way to make this chart look better, the stock is going to have a downward bias.
So how did IBM fare in the second quarter? Are things finally looking up? Your answer to that question depends upon how you spin Big Blue's results but to its credit, IBM is making progress towards actually growing revenue again at some point. As dreadful as having to utter that phrase sounds, it is still absolutely essential that IBM stop the declines in revenue and given how the stock has exploded higher, I have to think that investors have already assumed higher revenue is coming in the near future.
We all know that IBM's results are all about the cloud and what it calls its strategic imperatives. IBM is trying to remake itself from the out-of-date dinosaur that it is into a relevant company that can survive another hundred years. Whether that will happen or not is anyone's guess but in Q2, it got a little closer.
Cognitive Solutions saw revenue grow by 3.5% as cloud revenue flew higher by 54% during the quarter. Global Business Services was down 2% but strategic imperatives revenue was up 14%. Technology Services and Cloud Platforms was down 50bps but strategic imperatives revenue was up 35%. Systems revenue was hammered again as it lost 23% this quarter in what continues to be a hopeless, bottomless pit for IBM. And finally, Global Financing took it on the chin with an 11% loss, albeit in a very small segment.
So what can we learn from these results? If we look at the strategic imperatives revenue against the legacy portions of each business, the results are staggering. IBM is really making an effort to remake its revenue stream and it is working but one thing I've mentioned before is the idea that it may not be happening quickly enough. IBM is an enormous business, even after years of declines and replacing all of that revenue in any manner is going to be very challenging. Its Systems business seems to be going to zero (not really, but it is horrible) and Global Financing is having a hard time but of course, it is very small relative to the consolidated business. Can cloud revenue grow quickly enough to make up for the loss of revenue elsewhere? So far it hasn't but the declines seem to have slowed so perhaps IBM is nearing the sweet spot where it can match its strategic imperatives revenue gains with its legacy losses.
In the past, I've stated repeatedly that IBM was too far away from growing its imperatives revenue quickly enough to make up for the losses in its legacy businesses but it seems that is no longer the case. What started as a small proportion of revenue is now a significant piece of the business and at the rate it is growing, IBM could potentially see top line growth in the relatively near future if it can stop the hemorrhaging elsewhere. Can it do that? Maybe; we'll just have to wait and see. But at least the conversation can happen now whereas that was certainly not the case in the relatively recent past.
So what about going forward? This is the same revenue chart but with forward expectations built in and the results are interesting.
Source: Simply Wall St.
Analysts see a flat revenue trend for several years to come for IBM after years of declines and while I wouldn't normally be particularly excited about that, IBM has been so terrible in recent years that shareholders are probably jumping for joy at the prospect of flat revenue. As sad as that is, it is a big step forward for IBM if it can actually achieve it. With its imperatives revenue becoming so significant and continuing to grow at rapid rates, the stage is set for flat revenue and that's a positive for the stock.
As I mentioned, IBM's "strategy" for a very long time has been to just buy back as much stock as possible to juice EPS instead of actually creating a sustainable business model. That isn't the case as much as it used to be but if we take a look at this chart, we can see how IBM has been able to buy back so many shares.
Source: Simply Wall St.
Debt levels have exploded in the past couple of years as equity has declined and while IBM is nowhere near the point where financing would become an issue, having all of this debt on the balance sheet is very expensive and - more importantly - it means that it has already used up at least some of a potential source of future financing. IBM loves to buy other companies because it has proven 100% it cannot grow on its own so bigger deals will be harder to do because it has already loaded up its balance sheet. Again, it isn't a problem of liquidity but more so around flexibility in the future.
Finally, here is a chart of IBM's yield over the past ten years and you can see why some investors want to own the stock if for no other reason than its status as a bond replacement.
Source: Simply Wall St.
IBM has continued to raise its payout despite the fact that it has bought billions upon billions of dollars in stock and the fact that its revenue has been in perpetual decline for years now. And at 3.5%, its yield is very strong indeed and if yield is what you're after, you can do much worse. IBM's payout isn't going anywhere and if you don't care about the wild ride the stock may take you on in the coming years, its payout is terrific and will only get bigger. That's good enough for many people and while I wouldn't buy IBM just for the payout at $163, I respect that others would.
At 12.1 times this year's earnings, IBM isn't expensive by traditional measures but that assumes that it will find some way to grow in the near future. Its imperatives revenue is certainly on the right track but will it be enough to overcome the hopeless losers that still make up a huge portion of IBM's revenue? Right now I don't know but as I said, in the past I was pretty sure it wasn't. That's a positive change and while I'm still no bull on IBM, I'm not as bearish as I was either.
The fact remains that even analysts - which are usually overly bullish - have IBM hitting low single-digits EPS growth in the coming years as its only real source of growth is buybacks. That means that 12 times earnings is probably too much and it should be more like 10 times. Sentiment is very high on IBM right now so 10 times earnings isn't going to happen unless Q3 is terrible, for instance. But that doesn't mean one should rush out and buy IBM because while progress is being made, it is a long way from being a growth company. The dividend is nice but IBM is being valued like it is already growing revenue when it isn't and that's good enough for me to continue to avoid it despite the progress that is being made.
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.
