International Business Machines, Inc. (NYSE:IBM) faces revenue decline from its traditional hardware products and strives to diversify its business by increasing the share of cloud computing services. The key question to be addressed when investing in IBM shares is whether the company will be able to maintain a high level of capital spending given its already high leverage or not.
Financial results of the company are disappointing in general. Net income in FY2016 decreased by 10.0% YoY and income from continuing operations has been decreasing over the last 4 years (from $17.0bn in FY2012 to just $11.9bn in FY2016). The factors causing the bottom line decline unveil a serious crisis in the company's business.
First, revenue decreased by 2.2% in FY2016. This is less severe than an 11.9% drop in FY2015, but the worst part is that key IBM concerns still persist. The growth in revenues from new products that are represented by cloud computing and other services with higher added value cannot yet offset a decline in IBM's traditional, 'legacy' hardware products - namely storage and Unix-based servers where the company still has about 10% market share.
Revenue from these traditional products presented in a 'Systems' segment is declining fast - a 19.2% decrease in FY2016. Although there's some improvement in the revenue sources with 'Cognitive Solutions'' share in sales reaching 22.8% (growth from 21.8% YoY), it's still not enough to offset the decline in 'legacy' hardware sales. 'Cognitive Solutions' is the most marginal segment for IBM with a solid operating margin of 82%, but the largest part of IBM revenues is still derived from 'Technology Services & Cloud Platforms' (44.2% in sales) which has two-times lower margin.
Diversification and increasing the share of high-margin products is crucial for IBM today but it's costly. So the second reason for income decline is growth in expenses by 4.9% YoY. The company invests heavily in two business lines called "Strategic Imperatives" and "Cloud Computing." In 4Q16, these two lines demonstrated a solid growth in revenues of +12%/+33% respectively. To support these developments, in 2016, the company made substantial capital investments, increased its R&D spending and acquired 15 companies - a total of more than $15bn was spent on these elements.
The company's ability to finance its diversification and M&A activities is limited by borrowing capacity. IBM already has a vast amount of debt, which grew to $42.2bn at the end of 4Q16 (+5.7% YoY). Debt to equity ratio still remains at a solid 2.3x (some improvement YoY from 2.8x is due to an increase in retained earnings).
In its September 2016 press release dedicated to the downgrade of IBM's credit rating outlook from 'Stable' to 'Negative', Fitch Ratings agency underlined that the main source of pressure pulling the company's leverage up is R&D. It "expects that annual R&D will remain near $6 billion, up from closer to $5 billion in each of the prior two years, to support cloud capabilities around cognitive, cloud and security." So the level of debt is supposed to stay elevated for a prolonged period of time.
This increases interest expense but the burden is not that heavy yet. The average cost of debt in FY2016 was about 2.8% and it is likely to increase in the near future. About one-third of long-term debt is floating rate and it's expected to adjust to the anticipated further interest rate rise in the US in 2017. But due to the low interest rate environment, the negative impact is limited so we do not anticipate a significant charge from this side. Indeed, should interest rates rise by 0.5% (which is currently the most common forecast for 2017), additional pre-tax interest expense for IBM might amount $70mln only (about 0.5% of net income).
The company is able to maintain debt at these levels and its liquidity is strong. At first sight, $5.1bn of long-term debt is to be refinanced in FY2017 and another $8.9bn - in FY2018-19 (most likely the greater portion is attributable to FY2018 since the company grouped the data in the notes to the financial statements). But if we look deeper, the company has a $10.3bn credit facility readily available to cover these needs, so actually there's no threat to liquidity at least in the short and medium term.
The stock is low volatile with a beta of 0.87. Dividend yield is average at 3.3% and the payout has been growing constantly over the last years. The company is committed to maintaining payouts and the last decline in dividends was in 1999 during the "Dotcom crisis." The company also has $5.1bn remaining in the current share repurchase authorization and may use these operations to support the stock price.
However, sustainability of dividend payouts is dependent on net income since the leverage is already high. The company expects GAAP diluted earnings per share to decline to $11.95 in FY2017 after $12.38 in FY2016 and $13.42 in FY2015. The management explains this continuing decline (3.5% YoY) mostly by a still lagging increase in revenues from new products vs. the decline in traditional hardware systems and consulting business. So a potential investor in IBM shares should first consider whether the company will succeed in the transformation of its business or not - in the latter case, the stock price decline may offset the benefits from stable dividend income.
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.