IBM's (NYSE:IBM) shares are owned by many different kinds of investors. There are those whose interest is in seeing a steadily rising dividend. There are those looking at purely financial metrics and finding deep value in the company's shares and then there are those who see the company at one point ascending into the bright uplands of the Elysian Fields. I confess that as an investor I keep looking for a growth inflection point. That didn't happen this past quarter and in fact it took a massive amount of sales of intellectual property to keep the quarter from being an embarrassing miss. Licensing or selling intellectual property, which obviously has 100% margins, is not the stuff of a business inflection. There are some observers including this writer who do not think GAAP earnings should include assets sales as part of operating income.
I continue to believe that IBM will be unable to generate any positive alpha for a sustained time frame for years into the future. It simply hasn't figured out how to manage its transitions and it is now having to invest heavily to lay the groundwork for what it hopes will be sustained growth at some point in the future. IBM's dividend, although not its dividend increase strategy, appears secure. It has initiatives that will produce some growth. But this is not a growth company and there are no signs of it becoming one in the foreseeable future. And as detailed below, it is a company that is stretching accounting standards to achieve earnings estimates.
I think for IBM to have a sustained period of positive alpha it is going to have to show that it knows how to operate the many acquired businesses on a basis that it has significant organic growth, that it does not lose market share and that its profit margins are not eroding. Other investors may be satisfied with different metrics and accomplishments but last quarter simply was more of the same - a little better in some areas and worse in others and the total result has probably left observers a bit more negative about the outlook for the company - at least at the margin.
In my opinion, the shares fell because the headline earnings beat was the result of a significant reduction in the tax rate during the quarter and not an improvement in the business. The reported non-GAAP effective tax rate during the quarter was 14.2%. IBM settled a past tax matter during the quarter and booked a one-time tax gain of something more than $400 million. Many companies would choose a different method for portraying their tax provisions and would remove one-time events from operating earnings. Readers might suggest that IBM does lots of "virtual staging" to make its properties look pretty.
Sustained positive organic growth with at least constant market share and improvements in gross margin remain a glimmer in the eyes of some or an impossible dream in the eyes of some others. I will take a middle viewpoint and simply state that the strategies that IBM is pursuing are not enough to create a business inflection point and this quarter even with its ambiguities will not solve that issue for objective observers.
One of the problems with focusing on strategic imperatives as a growth driver is it basically presents half of a picture. It would rather be like taking that famous picture of Washington Crossing the Delaware and taking away the boat and river. 60% of IBM's revenues fell by 10% and 40% of its revenues grew by 15%. Were there some positive elements in the report? Perhaps. Unfortunately, objective observers are going to find negative details as well.
Just take "as a service" revenues. Exit rate of $7.5 billion and that is up more than 60% year on year. Sounds like IBM is becoming a strong competitor in the cloud - after all Amazon AWS (NASDAQ:AMZN) has a run rate of "only" $13 billion. The problem is that the major acquisition IBM made of Truven Health Care analytics and all of the other acquisitions made by IBM make it very difficult to determine just how well the company is doing as an operating entity. In fact, "as a service" revenues had a 12% sequential quarter increase of which the bulk are described as organic. IBM's cloud revenues, the part that competes directly against AWS and Microsoft (NASDAQ:MSFT) are probably growing in the same 40% range they have in the past - good, except that competitors are growing faster and except for the cannibalization cloud is causing within IBM's non-strategic offerings.
For example, strategic imperatives growth was 15% this quarter and that is better than 12% last quarter. On the other hand, the revenue piece of IBM that isn't strategic imperatives continues to fall at double-digit rates. Cognitive solutions revenues fell from $4.5 billion in Q2 to $4.2 billion in Q3. That is the segment that includes Watson. Yes, the summer can be a slower quarter than the spring. But if the company is going to be a cognitive solutions company as CEO Rometty advertises, then it needs to something a bit better than those results - or really it needs to do something much better than those results to show it has an engine in that business segment.
IBM's gross margins fell noticeably this past quarter and they fell more rapidly than had been the case in Q2. Cognitive solutions gross margins dropped from 82.2% to 80.4%. Systems gross margins dropped from 56.5% in Q2 to just 51.1% this quarter. Cognitive solutions is the business segment that includes Watson and it is really hard to see a high profit future for this company, if it is proving difficult to sell Watson at prices that provide an adequate return for the huge investments that have been made and will continue to be made in that business segment. For IBM as a whole, GAAP gross margins from continuing operations fell from 47.9% to 46.9%, sequentially.
To a certain extent, I imagine that some of the "faster" growth of IBM last quarter - we are talking minute amounts here - is inorganic in nature but the decline in margins has to do with the very high level of investments necessary in cognitive solutions and to integrate the plethora of acquisitions that the company has made in the recent past.
IBM's cloud revenues grew quite rapidly in Q3 and in particular its cloud as a service revenues were up 65% year over year and reached an annual run rate of $7.5 billion. Just how much of that is organic and how much of it represents the significant number of cloud revenue sources it has acquired of the past year is not something that is easy to determine. Some of the acquisitions such as Truven Health, Cleversafe and Merge Healthcare cost billions of dollars and might be expected to have been large enough to move the revenue growth meter. In addition to its large acquisitions, IBM acquired 17 other businesses of various sizes including the analytic and data capabilities of the Weather Channel.
One of the ancillary issues that occurs when going to such lengths to classify revenue in the right bucket is that some of the less popular segments get slighted. For example, over the years IBM has made numerous software acquisitions and to a lesser extent continues to do so. But the actual numbers presented in the earnings release portray a software business going through all of the transition impacts other legacy vendors are dealing with. It is just hard for anyone to comment that a growth rate of 3% in software is an achievement especially when almost all of the growth is inorganic. Some people read scripts better than others and this CFO is a master about taking disappointing information and spinning it. Trump could take some lesson, Hillary less so.
IBM's overall software portfolio has some glaring competitive issues. Its sales and marketing effort is notorious for its sclerotic processes and some of its portfolio has become obsolescent due to changes in user demands for particular solutions. These days about 30% of IBM's revenue is software.
If 30% of IBM's revenue is growing at 3% and that is considered to be an accomplishment, and if the 3% is mainly composed of inorganic elements, then company management has the kind of cognitive issues that Watson really can't solve.
I think that analysts who want to proclaim the success of IBM's cloud and strategic imperatives strategy and suggest that there has been any kind of a growth inflection point, really need to carefully consider what it means to repurpose "10,000 resources." The resources are people and people are not at their best when they are repurposed. Part of IBM's issues are employee productivity and so long as employees are resources the motivation necessary to get the company moving again is absent.
Over time the crucial question is going to be can IBM operate these acquired businesses in a profitable fashion that captures the growth opportunity. I think the results of Q3 are not positive in that regard and might indeed suggest that IBM's acquisition strategy is going to prove to be a bumpy and twisty road.
So, what of the future?
In the very short term, as most readers are aware, management left guidance alone. It did so because "while we may see a little less improvement from software revenue mix, we're more successful in monetizing out software through IP income." I personally think it is unfortunate when a large, legacy company that is considered a bastion of conservative practices advertises that through the sales of its assets it is able to ensure that it will deliver forecasted operating income. Lots of readers do not think that companies ought to be allowed to use stock-based comp as part of their non-GAAP income presentation and there are certainly arguments that can and have been made to support that contention. IBM is not in the business of selling its IP - it is really no different than any other asset sale - and using it as the basis for an earnings forecast is not very inspiring and casts doubt on the credibility of the rest of the company's presentation. The CFO said that sales of IP have legs, although the specifics of that were left a bit cloudy. But when investors wonder why IBM shares have what looks to be a bargain valuation, part of the answer has to do with reporting profits from sales of assets as operating income. It really isn't nice to mess with the software accounting gods.
In the interests of space, I won't try to repeat the commentary about tax provisions. I am not sure if an academic philologist could make sense of it - perhaps a Seeking Alpha editor might, but I am not too sure. But I think the answer was supposed to mean that if company guidance had been that the expected tax rate to be 18%, +/- 2 points and the tax rate is reported at 14%, then the fact that our reported earnings were salvaged that way shouldn't be further explored. I have nothing against companies that manage their tax rates to the lowest possible level - until it becomes an embarrassment. I think most readers accept that the 35% statutory rate in this country is an abomination. But manipulating the reporting of tax provisions in order to print a satisfactory earnings number is not something that inspires confidence. Again, investors wondering why IBM shares "don't get respect" in terms of valuation metrics need only to look at the "exchange" in the conference call regarding tax provisions to understand why most analysts have a hard time taking management commentary as the basis for much of their analysis.
Looking at 2017 and beyond, the current consensus expectations call for EPS of $14.11 and for a marginal decline in revenues. At this point, I think that the numbers suggest that EPS estimates are too high and are going to need some downward revision.
At the very least, I think the sales of intellectual property are going to be challenged to achieve the levels projected for the current year. IP sales have been $1.1 billion through nine months and I think, based on deciphering the commentary of the CFO, that sales of IP will be near but short of the company's all-time record of $1.7 billion. Apparently, the company needs a spare $500 million to maintain its Q4 profit estimate. Again, looking at the commentary of the CFO, there are limits as to what is available to be sold in the portfolio that are likely to make that category, which carries 100% margins, a consistent source of income. That said, I challenge anyone to read the relevant passage in the answer to the question from the B of A analyst and obtain absolute clarity as to what might happen with sales of intellectual property next year. There will be considerable sales of IP next year, based on the commentary, but the inference I have is that the sales will be less than or at best the same as this year and that is not congruent with an EPS increase in the absence of revenue growth.
And again, it appears as though the tax rate may also return to an 18% level, which will be a couple of hundred basis points greater than where it is likely to finish for 2016. Higher tax rate, flat or down IP sales and greater investment in cognitive systems yields lower, not higher earnings in 2017.
Management also talked about the need for investments to make Watson and the cognitive business reach scale. I won't quote the entire passage of the CFO's commentary as to why gross margins have been pressured and what is their outlook as they are simply too painful to see reprised, but one sentence is. "But keep in mind that we're also building new markets here and it's going to take some time for us to take the technologies and the processes that we bought for instance in our Watson Health business and now layer on the Watson technologies to get the ramp in growth that we expect to get out of some of them. So yes, good progress, yes, it's a long-term investment…" Long-term investments is a code word that means do not expect margins to get to a reasonable level anywhere in the future. Do not expect margin recovery in 2017. Best cut your estimates if they rely on higher margins.
The CFO talked about just how high margins were in the cognitive solutions business as though that was an explanation for why the margins are in the process of compressing. I suppose I missed that part at HBS when I was told that a business objective that is important is profit maximizing and not just on a relative basis.
And if you think that reading the transcript is a fraught exercise and trying to synthesize management comments is the equivalent of nailing mercury to a wall, listening to it was worse. The answer regarding organic vs. inorganic growth was surely a nadir of imprecision and obfuscation. I am not precisely certain as to my understanding of the CFO's answer but I think that acquisitions added 2% to reported revenues this quarter, the same as last quarter. What is not clear is whether that is sequential or year-over-year. What is clear is that IBM continues to shrink on an organic basis and there is no sign as to when the shrinkage will stabilize.
As of this writing there have been several price target cuts by major brokerages and I suspect that earnings revisions are coming as well. The current consensus numbers simply do not add up for 2017 and will have to come down to reflect the source of Q3's "performance."
What about free cash flow and how will it be used?
As mentioned earlier in this article, investors who own or might consider owning IBM shares do so for many different motivations. I have focused on analyzing the specific prospects for the business but there are many investors who do not care about that nearly as much as they care about the company's cash flow generation and dividend increases.
Through nine months IBM increased its CFFO by about 14%. Much of that had to do with the accelerated decline in Global Finance receivables. I do not think anyone ought to count on that as a permanent source of cash flow. In addition, other working capital sources produced a tailwind of about $1 billion. Those tailwinds are over and are likely to go the other way going forward and indeed in Q3 CFFO was essentially flat year-on-year.
Overall, in the first nine months of the year, IBM generated $13.3 billion in cash and spent almost $15 billion on capex, acquisitions, dividends and share repurchases. To fund the deficit, the company increased its net debt by $1.9 billion and sold $600 million of marketable securities.
Those trends reversed a bit in Q3 when total CFFO was $4.2 billion and the company spent a bit greater than $3 billion on the four categories listed above. The main difference was the lack of acquisitions during Q3 and that allowed IBM to pay down $2 billion of debt during the quarter.
Looking ahead, as noted, CFFO is running at unsustainable levels relative to the company's net income and is likely to decline going forward. Capex will probably remain at $3.5 billion. The company is forecasting free cash flow of almost $12 billion. The current run rate for dividends and share repurchase is just short of $8 billion. So, that leaves IBM with about $4 billion to spend on acquisitions without increasing its debt. My guess is that the size of the "budget" will decline a bit in 2017.
The point I'm trying to make is that the margin for this company to raise dividends is not huge. It can be done and it will probably be done next spring, but I would not count on any large dividend increase simply because the company is returning capital as fast as it can and just is not generating increasing cash flow necessary to fund substantial dividend increases. The dividend increase will probably be a greater percentage than the SSI increase and that may be enough for dividend-oriented investors. But for investors looking for positive alpha - this is not a company that should detain your attention. Maybe the downside is great, but there is little or no evidence that the company has figured out how to grow except in metaphor and obfuscation.
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.