IBM: After 22 Quarters The Turn Is Coming

Summary

  • IBM is calling an end to its declining sales.
  • The 10% jump higher in the shares is the largest which I can remember.
  • Shares have likely hit an inflection point and continue to trade at very reasonable multiples.

IBM (NYSE:IBM) reported 22 consecutive quarters of revenue declines in a row and yet its shares are spiking. The reason; the decline in third-quarter results was almost flat, in fact, the company believes that it can post growth again in Q4 of this year. If that were to happen, it would mark an end to a very painful era over the past five years for investors.

With prospects for flattish sales or even growth, IBM trades at relative cheap multiples at 13 times GAAP earnings, as the balance sheet is actually in reasonable shape, even after large buybacks (at high prices). As this could mark the first decent step into a recovery, as the company continues to underperform versus its peers, there is a prospect for multiple expansion. Even if shares trade at a modest discount compared to the market, a $200 target might be within reach if revenue growth could accelerate to perhaps >2% next year.

Close To Flat

IBM posted third quarter revenues of $19.1 billion, a 0.4% decline compared to last year, actually marking a dramatic improvement from the minus 2.7% decline posted for the nine months of this year.

The largest technology service & cloud platform business still saw a 3.3% decline to $8.5 billion. The better news is that the cognitive solutions business became the second largest business segment, seeing revenues increase by 3.9% to $4.4 billion after that segment posted flattish sales in the first half of the year. Data analytics (Watson Health) and security applications are responsible for the growth. The low margin global business service segments saw sales being down 2.3% to $4.2 billion, as IBM actually posted solid growth in its $1.7 billion systems business and its +$400 million financing unit.

Growth in higher margin areas, the impact of cost savings and overall sequential improvements in revenue trends have been helpful to margins. Gross margins were down 100 basis points to 45.9% after they are down 230 basis points so far this year. The company furthermore cut expenses in terms of SG&A as well as R&D which still runs at +$5.5 billion a year. Disappointing is a fairly big drop in IP related income, which was down more than $200 million to $308 million for the quarter.

The company posted operating profits being equal to 16% of sales, down a percentage point from the year before. Combined with a modest decline in sales, operating profits were down 6% to $3.1 billion. Net earnings declines were a little better as an already low effective tax rate dropped another 150 basis points to 11% of sales. As IBM continues to buy back stock, earnings per share were down just six cents to $2.93 per share.

The company anticipates that earnings will trend at this pace for the year, with GAAP earnings seen at $11.95 per share for the year.

Strategic Reporting?

Remember that IBM posted quarterly sales of $19.2 billion. At the same time, it announces that so-called strategic imperatives grew sales by 11% to $8.8 billion as the $4.1 billion cloud business saw 20% growth rate. So-called as-a-service run revenues were up a quarter to $9.4 billion per annum

What is remarkable is that strategic imperative and cloud revenues combined make up nearly $13 billion, equivalent to two-thirds of total sales. These combined sales are growing by roughly $1.6 billion in actual dollar terms. This is worrying as that means that the remaining $6.3 billion in sales from the ¨declining¨ divisions were down by more than $1.6 billion.

While this is worrying and IBM seems a bit promotional in pointing towards the growth areas, while failing to highlight the declining divisions, it is clear that sales are approaching the flat line. At the same time, the numbers work in IBM´s favour as the growth areas only get bigger and the troubled divisions only get smaller.

The Balance Sheet

IBM´s balance sheet remains a tricky one to read, being a mix of a ¨normal¨ company and a bank as a result of its huge financing business. The company holds $43.3 billion in various cash equivalent assets. Included in this are regular cash holdings, marketable securities, financing receivables, pension assets as well as investments & sundry assets.

On the liability side, some $63.2 billion in debt-like liabilities appear, consisting out of short and long-term debt as well as pension-related liabilities. This translates into a net debt load of $19.9 billion, compared to $18.1 billion in the same quarter last year. With operating earnings seen at roughly $12 billion this year and D&A charges seen around $4.5 billion a year, leverage ratios only come in at 1.2 times EBITDA according to my calculations. This is comforting as IBM has made some internal efforts to stabilise the business and invest for growth and while it has received a lot of scrutiny for buybacks, and rightfully so by buying back shares at high levels, the balance sheet remains in reasonable shape.

With shares trading at $160 following the prospects for revenue growth in the near term, shares do not even look that expensive. With GAAP earnings power of $12 per share, shares trade at 13 times earnings, in part aided by the very low tax rate. If IBM would pay a 20% tax rate (which is still reasonably low) earnings could be down some 10%, increasing the multiple to 15 times earnings. While smart tax management or even tax evasion warrants a separate discussion, the fact is that IBM and its shareholders continue to benefit from a low tax rate, until this is no longer allowed.

Upbeat, More Rome From Here

The conference call was very much telling in this case and a reason why the stock is up in my opinion. Management talked about the strategic imperatives and growth at the Technology Systems business on the back of the z14 mainframe which was only available for 2 weeks during the quarter.

Even the much promised and debated Watson technology was a driver for actual sales. Watson´s key AI solutions which generate information from the private, public and hybrid cloud are crucial to delivering on artificial intelligence from dispersed data sources. Talks about the application of Watson in Oncology and Life Sciences, in particular, could have huge positive consequences for humanity, and consequently for IBM and its shareholders as well in the future.

A balance sheet which might actually be in better shape than some fear, (as they ignore the large financing receivables, but do count the debt) and low earnings multiple, leaves room for multiple inflation and potential, especially if sales growth returns.

This article was written by

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The writer is a long term value investor and M.Sc graduate in Financial Markets with over 10 years experience. Value can be found in both long and short ideas and uses options to enhance the risk-return profile of investment ideas. Disclaimer: This article provides opinions and information, but does not contain recommendations or personal investment advice to any specific person for any particular purpose. Do your own research or obtain suitable personal advice.
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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.

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