IBM: Better To Stay Away

About: International Business Machines Corporation (IBM)
by: Investment Standard

Once an iconic company is now on a thorny way of restructuring its business - with limited success.

High degree of uncertainty on the company's future competitiveness and declining financial metrics does not let us to recommend it as a suitable buy for stable income-seeking investors.

The dividend yield is only moderate and does not compensate for the risks mentioned.

Once an iconic company, International Business Machines (NYSE:IBM) is now on a thorny way of restructuring its business - with limited success. Key reasons that don't let us recommend it as a suitable buy for a stable income-seeking investor are:

  • High degree of uncertainty on the company's future competitiveness;
  • financial metrics have been declining for the last several years;
  • stock price volatility is relatively high; and
  • the dividend yield is only moderate and does not compensate for the above.

As most of the hi-tech companies, IBM is currently suffering from stagnation on its traditional markets of on-premises hardware and thick-client software. Although the company is profitable, it has been demonstrating negative dynamics recently. Income from continuous operations before taxes has been declining steadily - from $15.8bn in 2014, it fell to $13.4bn in 2015. For 9m2016 the decline continued, and the metric amounted just $7.3bn - 32% down YoY.

A key reason for declining profitability is decreasing revenue, and it has been falling since 2013. Total sales exhibited the most significant drop in 2015. For nine months, they were down by 13.1% due to the divestiture of x86 server business to Lenovo (OTCPK:LNVGY) that led to a 4% decline. This drop was boosted by US dollar appreciation to emerging countries' currencies which resulted in another 8% loss of sales. IBM is affected by the shocks in developing markets because less than 44% of sales are from the stable Americas markets, and revenues from the BRIC countries dropped by 29%. In 2016, no significant volatility on currency markets was present, but for 9m2016, IBM's total revenue showed a further reduction of 2.6%.

The company sees its future in services with higher added value. IBM calls its key targets - cloud services, Software-as-a-Service (SAAS), Internet-of-Things - "strategic imperatives", and in 2015, the management set an objective to receive 40% of total revenue and sales amounting $40bn from these product lines by 2018. IBM was indeed trying to restructure its business lines, but didn't succeed yet. It is even more surprising given the fact that IBM was one of the largest IT vendors in the world and possessed a significant advantage. It is always easier to switch your existing customers to a new form of product (e.g. cloud server infrastructure vs. the on-site one) than to attract new clients.

We cannot say the revenue from new services is not growing at all. In fact, it is, and even in double digits. For instance, in 9m2016, "strategic imperatives" revenue increased by 15% and cloud computing revenue increased by an impressive 64% (YoY), but they are still quite small as a share of total revenues. Moreover, a decline in legacy solutions revenue base drives profitability back.

Now the situation is that IBM has lost the majority of its positions as a vendor of highly reliable hardware (e.g. it has only 14.1% market share in server equipment) and hasn't obtained a significant share in cloud services and related products it is so striving to succeed in. We see two main reasons for this. The first is that while pursuing short-term objectives of efficiency improvement, IBM fell into the trap of "cost cutting at any cost". This led to questionable decisions on laying off skilled workforce in the US and moving labor to countries with a lower cost which deprived the company of its ability to solve complex problems for clients. Management incentives tied up to earnings per share encouraged such short-term approach. Negative publicity related to the dismissal of staff in the US also harms the company's ability to compete for employees in a highly competitive market.

Another reason for the currently poor situation is that such a massive product line shift requires vast research, development, and engineering expense. In 9m2016, this cost already amounted $4.3bn (16% of gross profit). The other means for business expansion is extensive acquisition activity. Both these actions require substantial investments, but IBM is already highly leveraged, and its borrowing capacity is therefore constrained. The company's "Net Debt/EBITDA" ratio exceeded 4.0x for 9m2016 with some decline from 4.3x YoY. IBM is still highly rated (e.g. "Aa3" by Moody's), but the rating outlook has been made negative in 2016. Rating agencies' concerns are also mostly related to risks of product line change - whether the company will be able to achieve this goal.

High payout ratio (53% in 9m2016) is offset by the current level of stock prices. IBM's shares are currently about to break through the 52-week high. The dividend yield is constrained by this fact although it's above average (3.4%).

From a portfolio perspective, it should be noted that IBM can hardly bring any diversification benefit. It is highly correlated with the market having the beta of 0.86. Even though in the last 12 months, the stock price grew by 18%, outperforming the S&P 500 index by far (increased by 6% only), IBM's shares are much more volatile with the maximum drawdown in 2016; -27% compared to -16% for S&P 500.

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.