Avoid IBM Until It Can Regain Its Innovation Capability

|
About: International Business Machines Corporation (IBM), Includes: ARNC, BA, DLR, EOS, HD, HPQ, JNJ, LMT, MDLZ, MMM, O, SLP
by: William Stamm
Summary

International Business Machines' total return underperformed the DOW average for my 51 month test period by 43.10%, which is poor, you may as well leave the money in the bank.

International Business Machines' three-year forward S&P CFRA CAGR of 4% is low and does not seem to have a way to grow the business strongly except for cloud computing.

Earnings for International Business Machines' fourth quarter were mixed with earnings beating estimate, decreasing revenues and revenue missed estimate.

International Business Machines dividends are well above average at 4.7% yield and have been increased for the last 19 years with another increase expected in April.

International Business Machines (IBM), one of the largest computer software technology companies, is an avoid for the total return investor. International Business Machines has low growth and has plenty of cash, which it uses to increase the dividend each year. With an earnings beat in the last quarter, IBM will be watched for better growth and is avoid for The Good Business Portfolio, my IRA portfolio of good business companies that are balanced among all styles of investing until some definite growth can be seen in new products.

When I scanned the five-year chart, International Business Machines has a poor chart going down and to the right in a steady slope for all five years. The chart is the kind of chart you want to avoid, negative slope and volatile. The recent upswing may indicate some strength in a turnaround.

Chart Data by YCharts

Fundamentals of International Business Machines will be reviewed on the following topics below.

  • The Good Business Portfolio Guidelines
  • Total Return and Yearly Dividend
  • Last Quarter's Earnings
  • Company Business
  • Takeaways
  • Recent Portfolio Changes

I use a set of guidelines that I codified over the last few years to review the companies in The Good Business Portfolio (my portfolio) and other companies that I am considering for the portfolio. For a complete set of the guidelines, please see my article "The Good Business Portfolio: Update to Guidelines, August 2018." These guidelines provide me with a balanced portfolio of income, defensive, total return and growing companies that hopefully keeps me ahead of the Dow average.

Good Business Portfolio Guidelines

International Business Machines passes 8 of 11 Good Business Portfolio Guideline, a poor score (a good score is 10 or 11). These guidelines are only used to filter companies to be considered in the portfolio. Some of the points brought out by the guidelines are shown below.

  1. International Business Machines does meet my dividend guideline of having dividends increase for 8 of the last ten years and having a minimum of 1% yield, with 19 years of increasing dividends and a 4.7% yield. International Business Machines is, therefore, a choice for the dividend income investor but is mitigated by the poor total return. The payout ratio of dividends is moderate at 48%. After paying the dividend, this leaves cash remaining for investment in expanding the business, increasing the dividend and buying back shares.
  2. I have a capitalization guideline where the capitalization must be greater than $10 Billion. International Business Machines easily passes this guideline. International Business Machines is a large-cap company with a capitalization of $120 Billion. International Business Machines 2019 projected cash flow at $15.6 Billion is good allowing the company to have the means for company growth and dividend increases.
  3. I also require the CAGR going forward to be able to cover my yearly expenses and my RMD with a CAGR of 7%. My dividends provide 3.3% of the portfolio as income, and I need 1.9% more for a yearly distribution of 5.2% plus an inflation cushion of 1.8%. The three-year forward CAGR of 4% misses my guideline requirement. This poor future growth for International Business Machines may start to improve benefiting from the continued strong growth in the worldwide economy and cloud computing.
  4. My total return guideline is that total return must be greater than the Dow's total return over my test period. International Business Machines fails this guideline since the total return is -1.29%, less than the Dow's total return of 41.81%. Looking back five years, $10,000 invested five years ago would now be worth over $8,600 today. This makes International Business Machines a poor investment for the total return investor looking back.
  5. One of my guidelines is that the S&P CFRA rating must be three stars or better. IBM's S&P CFRA rating is four stars or buy with a target price to $167.0, passing the guideline. IBM's price is presently 22% below the target. International Business Machines is under the target price at present and has a relatively low PE ratio of 10, making International Business Machines a fair buy at this entry point with possible growth for the long-term investor if growth in cloud computing can increase.
  6. One of my guidelines is would I buy the whole company if I could. The answer is no. The total return is poor and makes International Business Machines a poor business to own for growth long term while the high dividend yield gives you some income. The Good Business Portfolio likes to embrace all kinds of investment styles but concentrates on buying businesses that can be understood, makes a fair profit, invests profits back into the business and also generates a fair income stream. Most of all what makes International Business Machines interesting is the potential long-term growth of the economy and population. Cloud computing may be the answer to returning IBM to above average growth. IBM was the king in computing 50 years ago, but they have not keep up with the changing technology.

Total Return and Yearly Dividend

The Good Business Portfolio Guidelines are just a screen to start with and not absolute rules. When I look at a company, the total return is a key parameter to see if it fits the objective of the Good Business Portfolio. International Business Machines strongly under-performs against the Dow baseline in my 51-month test compared to the Dow average. I chose the 51 month test period (starting January 1, 2015, and ending to date) because it includes the great year of 2017, and other years that had fair and bad performance. The poor total return of -1.29% makes International Business Machines a poor investment for the total return investor. International Business Machines has an above average dividend yield of 4.7% and has had increases for 19 years in a row with an estimated increase in April of $0.06 to $1.63 or 4% increase. International Business Machines is a fair choice for the dividend investor but is mitigated by the low total return and projected growth.

DOW's 51 Month total return baseline is 41.81%

Company name

51 Month total return

The difference from DOW baseline

Quarterly dividend percentage

IBM

-1.29%

-43.10%

4.7%

Click to enlarge

Last Quarter's Earnings

For the last quarter on January 22, 2019, International Business Machines reported earnings that beat expected by $.05 at $4.82, compared to last year at $5.17. Total revenue was higher at $21.79 Billion less than a year ago by 3.4% year over year and missed expected revenue by $32.84 Million. This was a mixed report with bottom line beating expected and the top line decreasing with a decrease compared to last year. The next earnings report will be out April 2019 and is expected to be $4.30 compared to last year at $3.64 a nice increase.

The graphic below gives a summary of the fourth quarter results.

Source: International Business Machines 4 th quarter earnings call slides

Business Overview

International Business Machines is one of the largest computer information companies in the United States and foreign countries.

As per excepts from Reuters:

International Business Machines Corporation, is a technology company. The Company operates through five segments: Cognitive Solutions, Global Business Services (GBS), Technology Services & Cloud Platforms, Systems, and Global Financing.

The Cognitive Solutions segment delivers a spectrum of capabilities, from descriptive, predictive and prescriptive analytics to cognitive systems. Global Business Services

The GBS segment provides clients with consulting, application management services and global process services.

The Technology Services & Cloud Platforms segment provides information technology (IT) infrastructure services. It delivers a portfolio of cloud, project-based, outsourcing and other managed services focused on clients' enterprise IT infrastructure environments.

The Systems segment provides clients with infrastructure technologies. It offers a range of systems designed to address computing capacity, security and performance needs of businesses, hyperscale cloud service providers and scientific computing organizations.

The Global Financing segment includes client financing, commercial financing, and remanufacturing and remarketing. Its client financing offers a lease, installment payment plan and loan financing to end users and internal clients."

Overall International Business Machines is a slow-growing business with 4% CAGR projected growth as the worldwide economy grows going forward with the increasing demand for more computer processing. The poor earnings and revenue growth gives International Business Machines the continuation of its slow growth as the business increases by foreign expansion and cloud computing.

The graphic below shows the growth for the cloud platforms segments a key area of future growth.

Source: International Business Machines 4 th quarter earnings call slides

The Fed has kept interest rates low for some years, and on December 19, 2018, they raised the base rate of 0.25%, which was expected. I believe that they will go slow in 2019, which should help keep the economy on a growth path. If infrastructure spending can be increased, this will even increase the United States growth going forward with better economics for the consumer. The Fed lowered GDP projection for 2019 which may mean they are getting to neutral on the economy, projecting two rate increases for 2019. The recent volatility may keep the Fed on hold. At the Fed meeting in January, the statement was a wait and see and a bit more dovish than the last meeting.

From January 22, 2019, earnings release Jim Kavanaugh (Chief Financial Officer) said:

The fourth quarter capped off a year where we grew revenue, operating pre-tax income, and operating earnings per share. We stabilized our margin as we moved through the year, and we expanded gross and pre-tax margin in the fourth quarter. We continued to invest and take actions to shift our business toward higher-value areas like hybrid cloud and AI, including the announcement of our acquisition of Red Hat.

Total services revenue was up 2%. We had steady improvement in Global Business Services throughout the year, with 6% growth in the fourth quarter and revenue growth and gross margin expansion across all three of our GBS business lines.

We’re adding innovative services, like the world’s first commercial quantum computer available on the IBM Cloud. You may have seen that ExxonMobil is already using it to help address its most complex business challenges, such as energy exploration and chemicals manufacturing. The number of new clients using IBM Cloud Private accelerated in the fourth quarter, and adoption is growing for our IBM Cloud Private for Data platform, which was named a leader in the first quarter 2019 Forrester Wave report on Enterprise Insight Platforms. All of this is a validation of our hybrid, open approach to cloud, and we have a strong foundation from which to drive synergies across the business with the addition of Red Hat.

Let me pause here to remind you of the value we see from the combination of IBM and Red Hat, which is all about accelerating hybrid cloud adoption. The client response to the announcement has been overwhelmingly positive. They understand the power of this acquisition, and the combination of IBM and Red Hat capabilities, in helping them move beyond their initial cloud work to really shift their business applications to the cloud.

This shows the feelings of top management for the continued growth of the International Business Machines business and shareholder return with an increase in future growth. International Business Machines has slow constant growth and has the potential to grow as the world economy grows to need more software tools and processors for the cloud.

The graphic below shows the summary going forward for 2018 - 2019.

Source: International Business Machines 4 th quarter earnings call slides

Takeaways

International Business Machines is a poor investment choice for the total return investor with its well-below-average total return. International Business Machines will not be considered for The Good Business Portfolio, but I will be watching for future growth. It’s my opinion that International Business Machines should be avoided because of its slow growth and poor total return.

Recent Portfolio Changes

I intend to watch the earnings reports for the companies in the portfolio and may finally decide to trim my high flyers that are over 8% of the portfolio so I can invest in good companies on my buy list.

  • On March 11 the portfolio reduced the position of Arconic (ARNC) from 0.4% of the portfolio to 0.3%. I will sell the rest of this position within the month. The dividend was just cut, and forward growth is under-par.
  • On March 7 added to position of Simulation Plus (SLP) from 0.33% of the portfolio to 0.45%. I will add slowly to this position as available cash allows.
  • On March 4, trimmed position of Hewlett Packard (HPQ) from 1.3% of the portfolio to 1.0%. The last earnings report was poor, and future growth looks weak at 2%. Time to sell HPQ for a better business.
  • On February 28, trimmed position of Boeing (BA) from 16.1% of the portfolio to 15.8%. I love Boeing, but you have to have diversification.
  • On February 2 increased position of Realty Income Corp. (O) to 0.7% of the portfolio; I could use a bit more steady monthly income.
  • On January 30 increased the position of Simulations Plus from 0.2% of the portfolio to 0.4%. I think their product may be the product of the future for drug testing.
  • On January 28 Bought a starter position of Realty Income Corp. I could use a bit more steady income and hope to add to this holding in the future. Realty Income Corp. is now 0.4% of the portfolio.
  • On January 28 sold the remaining portion of Mondelez (MDLZ). The forward growth does not look good enough.
  • On January 24 increased the position of Digital Reality Investors (DLR) from 3.1% of the portfolio to 3.6%. I want to get DLR up to a full position of 4%.
  • On January 16 sold the remaining shares of 3M (MMM). I decided to sell this small position in order to reduce the number of positions with a new target number of 20 positions max from 25.
  • On January 11 started a new position in Lockheed (LMT) at 0.65% of the portfolio.
  • On January 9 trimmed Mondelez from 1.32% of the portfolio to 0.64%. The growth rate looks low going forward, and the portfolio is looking at Lockheed as a replacement.

The Good Business Portfolio trims a position when it gets above 8% of the portfolio. The four top companies in the portfolio are: Johnson & Johnson (JNJ) is 8.3% of the portfolio, Eaton Vance Enhanced Equity Income Fund II (EOS) is 8.2% of the portfolio, Home Depot (HD) is 8.8% of the portfolio and Boeing is 14.8% of the portfolio. Therefore BA, EOS, JNJ, and Home Depot are now in trim position, but I am letting them run a bit since they are great companies.

Boeing is going to be pressed to 15% of the portfolio because of it being cash positive on 787 deferred plane costs at $316 Million in the first quarter of 2017, an increase from the fourth quarter. The first quarter earnings for 2018 were unbelievable at $3.64 compared to expected at $2.64. Farnborough Air Show sales in dollar value just beat out Air-Bus by about $6 Billion, and both companies had a great number of orders. Boeing received an order for 18 more KC-46A planes. The second quarter 2018 earnings beat expectations by $0.06 at $3.33, but a good report was hurt by a write off expense on the KC-46 which has started delivery in 2019. Two KC-46A tankers were delivered in January 2019. As a result of the good fourth-quarter earnings, S&P CFRA raised the one-year price target to $500 for a possible 20% upside potential.

JNJ will be pressed to 9% of the portfolio because of its defensive nature in this post-BREXIT world. Earnings in the last quarter beat on the top and bottom line and Mr. Market did nothing. JNJ has an estimated dividend increase to $0.97/Qtr. in April 2019, which will be 57 years in a row of increases. JNJ is not a trading stock but a hold forever; it is now a strong buy as the healthcare sector remains under pressure.

For the total Good Business Portfolio, please see my article on The Good Business Portfolio: 2018 4th Quarter Earnings and Performance Review for the complete portfolio list and performance. Become a real-time follower, and you will get each quarter's performance after the next earnings season is over.

Disclosure: I am/we are long BA, JNJ, HD, OHI, MO, IR, DLR, GE, PM, ADP, PEP, V, ARNC. 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: Of course, this is not a recommendation to buy or sell, and you should always do your own research and talk to your financial advisor before any purchase or sale. This is how I manage my IRA retirement account, and the opinions of the companies are my own.