IBM Earnings: Legacy Biz Vs. Emerging Growth Segments

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No question there has been signs of stabilization in IBM's business and financials.

Cash-flow has been stable. IBM's free-cash-flow yield is 9%.

One big problem: the Strategic Imperatives business - near 40% of total rev - seeing slowing growth.

Investors need to see revenue growth eventually.

IBM (NYSE:IBM) is scheduled to report their earnings after the bell on Monday, October 17th, 2016.

Analyst consensus is expecting $3.23 in earnings per share (EPS) on $18.998 billion in revenue for expected year-over-year (y/y) declines of -3% in EPS and -1% in revenue.

If consensus estimates are met, this will be the slowest rate of contraction in IBM's financial metrics since late 2012, 2013.

Here is the y/y declines in EPS and revenue going back to 2011:

y/y rev gro y/y EPS gro
9/16 (est) -1% -3%
9/15 -14% -9%
9/14 -10% -8%
9/13 0% +10%
9/12 -5% +10%
9/11 +8% +16%

Source: earnings reports, Q's, and the numbers are NOT adjusted for currency, etc.

17 of the last 21 quarters have seen y/y declines in revenue for Big Blue.

That being said, from viewing the progression of revenue and EPS consensus estimates, some of the consistently-downward pressure is abating and the forward numbers look to be stabilizing.

IBM's cons est's 9/16 (est) 6/16 3/16 12/15
2018 EPS $14.81 $14.90 $15.10 $15.10
2017 EPS $14.09 $14.11 $14.14 $14.17
2016 EPS $13.51 $13.51 $13.53 $13.87
2018 EPS gro rt 5% 6% 7% 9%
2017 EPS gro rt 4% 4% 5% 2%
2016 EPS gro rt -10% -10% -9% -7%
2018 P.E (est) 10(x) 11(x) 9(x) 8(x)
2017 P.E (est) 11(x) 11(x) 10(x) 9(x)
2016 P.E (est) 11(x) 12(x) 10(x) 9(x)
2018 revenue est $79.96 $78.86 $79.0 $78.5
2018 revenue est $79.3 $78.94 $79.0 $77.01
2016 revenue est $79.58 $79.17 $79.25 $78.08
2018 rev est gro rt 1% 0% 0% 2%
2017 rev est gro rt 0% 0% 0% -1%
2018 rev est gro rt -3% -3% -3% -4%

Source: current estimates based on 10/13/16 Thomson Reuters consensus estimates. Historical estimates based on estimates following that quarter's report.

The positive in the above table indicates that revenue estimates look to be stabilizing, while EPS estimates are still eroding. This could possibly be due to the higher-margin legacy business still eroding while the Strategic Imperatives business is still growing.

Margins might have a hard time expanding without revenue growth.

Here is something I worry about re IBM's Strategic Imperatives business:

SI cc rev gro % of IBM rev
q2 '16 +12% 38%
q1 '16 +17% 37%
q4 '15 +16%
q3 '15 +27% 28%
q2 '15 +30% 28%

Source: Morningstar, Street research, conf calls notes, etc.

  • SI = strategic imperatives segment
  • cc = constant currency revenue growth

Valuation: as the 2nd table indicates IBM is trading about 10(x) forward earnings growth, for which expectations are quite low and 8(x) cash-flow for the tech giant, so the Street is expecting very little improvement out of the Tech giant, at least for the 3rd quarter.

What I find interesting is that if IBM had targeted "operating cash-flow per share" (OCFPS) instead of the $20 in EPS by 2015, management would have been far closer to hitting that target, than the EPS goal. (IBM's OCFPS was $18.59 for the 4-quarter trailing period ended June 30 '16, versus the 4-quarter trailing EPS of $13.37.)

IBM has an approximate 3.6% dividend yield at its current price with the dividend representing about 1/3rd's of IBM's free-cash-flow, so Big Blue can continue to repurchase stock without jeopardizing the dividend.

IBM has slowed their share repurchases in recent quarters, spending about $850 million average the last three quarters. The buyback unfortunately, like a lot of companies, repo'ed more stock closer to $200 per share than the current range of $130 - $150 per share. (I'm sure IBM management would like to have back the near $14 billion spent on the buyback in Q4 '13 and Q1 '14, when the stock was trading around $175 - $190 per share. )

One reader commented about the long-term debt being issued for share repo's but IBM increased long-term debt just $8 billion from late 2013, through $q2 '16, or from $32 to $40 billion as of June 30 '16.

The fact is IBM IBM is averaging roughly $13 billion in 4-quarter trailing free-cash-flow since 2013, with a range of $10 - $15 billion, so management doesn't need to issue a lot of debt to supplement the buyback.

With a 9% free-cash-flow yield (4-quarter trailing free-cash-flow divided by IBM's market cap) the FCF yield isn't as attractive as Q1 '16, but is still quite healthy.

Conclusion: In my opinion, Ginny Rometty was dealt a tough deck of cards. The erosion in the legacy business, and the rapid emergence of the Cloud was imminent when Sam Palmisano stepped down, and thus turning IBM is not like turning a speedboat.

That being said IBM has been through many of these transitions beginning with the move away from mainframes to PC's and servers in the 1980 and 1990's and now the next major shift involving the Cloud.

I think it would be acceptable to see the Strategic Imperatives business grow "mid-teen's" going forward if the legacy businesses like Global Business Services and Global Tech Services stabilize. Software too, which had negative low-single-digit revenue growth, even if it too just stabilized, would help the numbers.

IBM is facing the exact same dynamic that Oracle (NYSE:ORCL) and Microsoft (NASDAQ:MSFT) are facing: slow to no-growth or even declining legacy businesses with rapidly emerging Cloud and Security and growth segments which aren't yet substantial enough to move the needle.

Per IBM's investor relations department, Big Blue has acquired 26 companies since the start of 2015, and with a debt-to-cap ratio of 34% and total term debt of $40 billion (not to mention $10 billion in cash) Big Blue could make a bigger acquisition (in my opinion) if management really wanted a needle mover so to speak.

As of Q2 '16, Cloud-specific revenue was $12 billion, which I estimate to be a little more than 50% of the Strategic Imperative or "Newco" (new company growth segments).

Morgan Stanley's analyst made a great call on IBM in Q1 '16 when the stock was trading around $120 per share, calling a bottom for the stock. The analyst should be commended for that call.

Fundamental summary: Financial metrics look to be stabilizing, although Street consensus hasn't yet lifted forward revenue growth estimates. Big Blue needs some revenue growth. These mega-transitions take time for technology companies the size of IBM. However investors need to see some progress soon.

Technical summary: I'd like to see the stock continue to trade above $150 after earnings. The stock could see resistance if trades up to $175. Through $175 and I do think the stock could make all-time-highs eventually.

Sentiment: My impression is a many investors have lost interest in the stock. IBM was a dramatic underperformer for 2013 - 2015. In 2016, the stock is up 15% and is still not attracting much attention.

With about a 1.5% position in the stock for clients (and the position has been held for years, back to 2010) the stock won't be bought in front of earnings, but instead the results will be evaluated.

The big tell will be how forward estimates change for 2017 and 2018 after the Q3 '16 results.

Here are the earlier articles on Big Blue: here, and here

Disclosure: I am/we are long IBM, MSFT, ORCL.

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.