International Business Machines (NYSE:IBM) is about as blue-chip as it gets. But being a longtime stalwart of the tech services industry doesn't exactly mean it's got an unassailable position, so investors have been finding out over recent years. Competition from cloud computing, the proliferation of business services at other firms, the move away from the PC in general, and the strengthening positions of Apple and Microsoft have all combined to produce a very challenging environment for IBM. How has management navigated these challenging waters, and which way is the wind blowing with regards to profitability and its competitive position? Finally, what has management done to turn the tide and help keep shareholders happy? In short, the disruption of the cloud revolution has muddied the waters and management has flailed around looking for answers. So far, the answers they've come up with have been a mixed bag.
I typically start with looking at top-line growth (or negative growth, as the case may be), and kind of drill down from there. So, looking at the income statement, one can see that revenue has suffered in recent years, especially as its server business (and related services), an important cornerstone to the firm's profitability, has been hit especially hard as the cloud has made many of the expensive servers IBM provides somewhat redundant and less worth the cost to companies looking to house data for less. Let's take a look at the trend over the last decade:
As can clearly be shown above, it's not a pretty picture. In the last 10 years, IBM's revenues hit a peak in 2011 of $106.9 billion, and have since fallen precipitously to just $81.7 billion. That is a growth rate of -6.5%. Obviously, this is an unsustainable situation, and something that has management frantically scrambling to figure out how to rectify the situation. Oddly enough, it's the IBM model itself is to blame. Its hyper-focus on business services over retail products produced fat margins and steady business, which of course, attracted all sorts of competitors. The big shock, is that IBM's competitive position eroded so quickly, and its protective "moat" was not nearly as wide as previously believed. Still, the company is at somewhat of a crossroads right now, and recent events could create a nice buying opportunity, if management can adapt to the changing competitive environment.
As always, I like to compare revenue to the cost of sales generation, just to make sure the firm isn't slashing prices/margins simply to drive sales. The following chart seems to be in line with what an astute investor would expect, and shows nothing out of the ordinary in that regard. ("Cost of Revenue" means the same thing as "Cost of Goods Sold," or "Cost of Generating Sales." It's all interchangeable).
Just to be sure, let's compare, using a ratio called Gross Margin (Revenue minus COGS, divided by revenue, expressed as a percentage), and see if there is a discernible trend, one way or the other. From full fiscal year 2006 to 2015, gross margins actually rose from 41.9% to 49.8% (hitting exactly 50% in 2014). That is at least some indication that sales are not being driven artificially high and what is highly likely, is that the company is refocusing on its more profitable lines of business as sales slow. That is a smart strategy, and a typical move for a management team keen on stabilizing earnings and wringing efficiencies out of existing business. Revenues have fallen rapidly, even with improving margins.
As the chart shows, net income rose nicely, peaking out in 2011 along with revenue, and falling since (though buoyed somewhat by the growth in margins). It's all fine and good to refocus around the core of one's business, and redeploy capital to the most profitable aspects of the sales pipeline but, eventually, if earnings consistently grow, top-line revenue growth should return. Otherwise, IBM is simply in a holding pattern until they can figure out a way forward. The EPS (earnings per share) numbers are even more telling, though, and indicative of the kind of financial manipulation executives have seen fit to employ.
If one didn't know any better, just looking at EPS numbers, an investor might think overall the trend is still a good one. After all, EPS have grown nicely from $6.11 per share in 2006, to $13.42 in 2015, with one temporary blip in 2014, when EPS dropped from a peak of $14.94 to $11.90. At least, earnings have started a healthy rebound after that short misstep, right? Not exactly.
While net income dropped from $16.5 billion in 2013 to $12 billion in 2014 (a negative growth rate of nearly 28%), EPS fell by considerably less, going from $14.94 to $11.90, a drop of only 20%, nearly a third less. What does all of this point to? Massive share buybacks. Let's take a look there:
As shown in the graphic above, IBM has been almost frantically buying back its own shares. While this is good for shareholders, at least in terms of per share ownership, in the long-run, such moves are not going to keep the share price climbing as real growth in earnings is being masked. IBM has successfully reduced its overall outstanding shares from 1.55 billion in 2006, to 0.98 billion in 2015, a reduction of about 37%. To put it a different way, if share count remained constant since 2006 at 1.55 billion, then 2015's EPS would be $8.51, rather than the $13.42 that's been reported (that's a difference of 57.7%!). With all of those buybacks, how has IBM's cash position been affected, and how has it financed all of this?
Well, obviously from the chart above, IBM's cash on hand has taken a bit of a nosedive, which also has to do with its rising dividend, which I will discuss a bit later on. For now, this is a telling picture. And as for the financing aspect? Well, Big Blue has seen fit to take on more and more long-term debt as interest rates have been fortunately low. Now that rates are climbing, though, management's ability to refinance its obligations at favorable rates will go down, as will its cash on hand, as the average cost of its debt load climbs slowly higher.
Another way to keep investors relatively happy during this period of uncertainty, is to pay a hefty dividend while investors wait for the new corporate strategy of heightened efficiencies and refocus on core businesses slowly starts to (hopefully) bear fruit (not apples though, that's not allowed on company property, I think). Anyway, let's take a gander at how dividends have grown over the preceding decade, shall we?
Finally, the full extent of the capital return program becomes quite clear. Management has basically tried to cover up its top-line shortfall by throwing cash at the problem, in a true exercise of financial engineering (this time, the term is quite appropriate). Dividends per share have grown at an astounding rate, going from $1.10 per share in 2006, to $5.40 in the trailing twelve month period, an annual growth of 15.56%. Considering the alarming decline in revenues, and growing costs of its outstanding debt, it is only logical to begin to wonder just how sustainable is this current trend of buying back shares and paying out dividends? Well, one of the most concerning things of all is the surging dividend payout ratio. When an investor sees that, it is clearly a sign of either slowing dividend growth ahead, or even an outright cut. So income investors, be very wary, and pay close attention to the following graphic.
The dividend payout ratio has nearly doubled in about 5 years, after having remained fairly steady at around 20% for years leading up to 2012. This trend is clearly unsustainable, and is already a real threat to retained earnings and cash flow.
The Long and Short of It
Basically, until IBM renewed focus on efficiencies of scale and its suite of core business begins to reverse the trend in topline growth and we see that trend continue for more than just a year or two, then perhaps the bottom-line can start to mean something again. I still think it's too early to make a real judgment call here, though, current shareholders should refrain from accumulating more shares. I think the verdict is still out as to whether or not IBM's competitive advantage has eroded permanently or not. If I had to guess, I'd say yes, but not by that much. I'm not saying to short the stock, but I'd also advise against putting new money to work into this blue chip until the sales mix and overall revenue picture becomes much more clear. I also dislike how management has focused so much of its energies on financial engineering to prop up the stock, that is usually a sign of a stagnant corporate culture, and one that is used to resting on its laurels. Time, as always, will tell which direction Big Blue is ultimately headed.
*All financial data courtesy of Morningstar Investment Services.
*All charts created by the author, Ben Black, utilizing data exported from Morningstar.
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.
Additional disclosure: I included the Excel Workbook in the supporting documents section, just in case this became a PRO article. I only suspected that was a possibility because of the "Investment Snapshot" which is completely new to me, and appears to be for the benefit of PRO readers.