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Scaling Back My Position In IBM After Fourteen Long Years

Summary

I was attracted to IBM in 2005 by its long contributions to improving the efficiency of large organizations, strong competitive position, sticky customer base, earnings growth and declining share count.

I added more shares following Watson’s Jeopardy win over the reigning world champion on the basis that IBM’s AI can “outthink” human and be scaled quickly.

While some parts of my thesis have held up, IBM’s revenue and earnings have disappointed, and the stock has languished over the last 5 years.

Even though the valuation today is undemanding, I feel the KPIs provided are insufficient to help me arrive at an informed view on its longer term prospects, and its culture not sufficiently hard-charging in the fast changing IT sector.

After fourteen frustrating years, I have decided that it is time to consider scaling back my position in IBM.

Background:

I first bought IBM (the “Company”) shares in 2005 and have added to my position over the years. My 2005 purchases have done OK (slightly less than doubled in 14 years, excluding dividends), but subsequent purchases have been disappointing. Even though I’m still sitting on a modest profit as a whole, after re-examining my original investment rationale and IBM’s competitive position today, I concluded that there are better ways to be a part of the IT/digital revolution.

My original thesis (2005-2013):

I was originally attracted to IBM for the following reasons:

  • The Company has contributed to improving the efficiency of corporates and government organizations over a long period of time, and I expected this to continue

  • Solid competitive position:

    • Strong brand premium — IBM products and services command a premium pricing, as “no IT manager ever got fired for going with IBM”

    • Deeply embedded within large corporates and government organizations

    • Wide moats and sticky revenues due to high switching costs of installed legacy hardware and software

  • Expected earnings growth: After Lou Gerstner turned the Company around and handed the reins to Samuael Palmisano, there was evidence of a resumption of earnings uptrend driven by Global Business Service (“GBS”) and Technology Services (“TS”) growth, as well as strong projected revenue and margin growth from the software division through some organic growth, aggressive acquisitions and cost cuts

  • Watson’s groundbreaking victory over the reigning Jeopardy world champion Ken Jennings in 2011 led me to believe that IBM had developed winning artificial intelligence capabilities that could propel the Company to new heights. I added to my position amidst the publicity, excitement and expectation that IBM is able to process qualitative, unstructured information better than human beings to solve difficult problems (e.g., cure cancer), and with anticipation that IBM would quickly bring this knowhow to both large and small organizations to become the world leader in AI

  • Declining share count as IBM aggressively re-purchased undervalued shares, which benefited long term holders

I was optimistic that IBM would become a clear and undisputed leader in powering the digital and AI revolution and deliver value to shareholders.

Update on thesis—Fourteen years later

The world has changed dramatically over the last 14 years—a very long hold period and an eternity in IT.  While some elements of my investment thesis still hold, others have turned out to be weaker than I expected.

IBM’s competitive positioning and customer base:

All 3 points on IBM’s competitive position in my original thesis—the strong brand premium, dominance in large corporates/government and customer stickiness—are still true but have turned out to be weaker that I than I had anticipated.

IBM’s strength has been in the large corporate enterprise segment (in their 2018 annual report, they proudly emphasize the fact that 47 of the Fortune 50 are their customers) which in aggregate appeared to have grown IT spending less compared to the fast growing small/medium enterprises (SMEs) segment that has driven the bulk of IT spending growth. By focusing on the larger enterprise segment, IBM has less exposure to the growth of SMEs—many of which have since grown in size and IT budgets. The democratization of software development have led many SMEs, which do not see the need to pay a premium for the “I went with IBM” safety blanket, to either develop the capability in house and/or work with cheaper and more flexible alternatives, including Amazon’s AWS and Microsoft’s Cloud service, which were little more than a twinkling in their parent companies’ eyes 14 years ago . These companies are quite unlikely to outsource or ditch their incumbent providers for IBM due to high switching costs inherent in IT.

Expected earnings growth:

The Company has done an excellent job putting its best foot foward in its recent earnings reports, but revenues and earnings growth have continued to fall short of expectation, even after my downward reset following the end-2014 disappointment when IBM CEO Ginny Rommety abruptly abandoned the EPS guidance of “$20 by 2105” established in the Roadmap 2015 plan put forth by previous CEO Samuel Palmisano. The divestments of non-core “empty calorie” hardware divisions has provided more cash for share buybacks, but I am concerned there may be still more empty calories emerging within the Company.

While 2018 numbers provide some hope that the Company’s performance is bottoming out and turning around, it is hard for me to build a case that there is strong momentum building up:

  • Cognitive Solutions: I expected “strategic initiatives” in this division to accelerate overall growth. Management has shone the spotlight on and encouraged investors to focus on the growth of strategic imperatives and its revenues as a percentage of the cognitive solutions segment. True, this percentage has quickly grown to almost 50% of Cognitive Solutions revenues, but as the division’s overall revenues have grown slowly, it appears that these strategic initiatives have merely replaced sales declines in its “traditional” software. Overall, Cognitive Solutions revenue growth has been tepid, not what I would have expected given the growth potential of software and Watson. My (untested) hypotheses include:

    • As mentioned above, IBM is more heavily geared towards serving large enterprises and government, which have comparatively slower growing IT budgets;

    • The Company’s new “strategic imperatives” capabilities, which replace the legacy revenues, do not command meaningful premium pricing as they are not sufficiently innovative or differentiated compared to what competitors have to offer, and are playing catch-up;

    • I overestimated Watson’s capabilities and speed to market. The recent announcements of the discontinuation of Watson Workplace and cutbacks in Watson for drug discovery would indicate that the technology is either over-hyped, subpar, not ready for prime time, or needs better “go to market” execution;

    • Or, is the Company still in the midst of transitioning its software revenue model from a traditional software licensing model (with large upfront + maintenance fees) into a SaaS model with lower but recurring revenues?

  • The Global Business Solutions (GBS) segment is growing low single-digits, but margins are lower than IBM’s other segments: While there is much publicity around IBM’s focus on Blockchain, I question how much in revenues Blockchain will generate for IBM outside of GBS. If successful against its far more nimble competitors, the much touted global logistics and food safety initiatives could revolutionize these sectors, but it’s unclear if this will move the needle for shareholders. In addition, I see the high priced acquisition of Red Hat as more of a defensive rather than an strategic offensive move — Red Hat’s open source culture is fundamentally different from IBM’s roots as a proprietary software company, and I fear it could present meaningful cultural and integration challenges.

  • Global Tehnologies Services (GTS) revenues are also not growing as quickly as competitors’, suggesting that IBM’s offerings are either not targeted at the right segments, or its implementation of cloud infrastructure offering is less competitive compared to others (like AWS) which have been experiencing much higher growth in recent years.

  • Systems solutions: The long term declining sales and margins in the Systems Segment over time is worrisome. As low cost distributed servers become more powerful, reliable and fault tolerant, the market for IBM’s hardware may be shrinking and could become a niche product for the relatively few customers that require zero fault tolerance systems (e.g., payment processors, banks and airlines).

  • Innovation: IBM’s leading R&D capabilities and record number of patent fillings is impressive, but its licensing revenues of c. USD1 billion constitutes just about 10% of pre-tax income, have been rather lumpy, and does not appear to be translating into revenue growth for IBM’s own businesses. IBM’s leading edge Quantum computing research is ground breaking, and the performance of Watson Debater in a recent debate competition (you can watch it on YouTube) was impressive, but will they, like Watson AI, take far more work and time than expected before they can create value for customers and shareholders? And will they ultimately emerge the winners against other competitors’ offerings?

A few other considerations:

The key performance indicators (KPIs) provided could be more insightful: the metrics IBM provide are not quite sufficient to help me arrive at an informed judgment of the Company’s future prospects. While this level of disclosure might have been acceptable when the company was on a continued strong growth trajectory, that has unfortunately not been the case here.

The culture: I have had the opportunity to attend a few live IBM presentations on its new technologies and was able to have one-on-one conversations with the presenters, and just did not feel the same excitement, energy and sense of mission that I have found in high growth tech companies. Granted, my sample size is minuscule and anecdotal, and such a culture is well suited towards serving its large corporate and government customers, but I left the events feeling that the Company did not have the drive needed to bring technological innovation to market quickly and effectively.

Valuation: IBM’s current valuation is undemanding (price earnings ratio of under 15), is highly cash flow generative (free cash flow yield of over 9%) and pays out a juicy dividend (yield of 4.5%) which hopefully is sustainable after the Red Hat acquisition. While IBM has been able to boost earnings per share by buying back lots of shares, the Company needs to get back on a growth trajectory or I fear it could gradually descend into a downward spiral. Absent evidence of growth drivers that portend an impending turnaround (the current metrics don’t help shed light on it), there is no visible indication that its intrinsic value is about to move up soon.

In conclusion:

Fourteen years is a long time to wait for IBM to create value for shareholders, but it has gone nowhere and continued to disappoint even with my lowered expectations. I can no longer justify keeping IBM as one of my larger positions, and it is time to consider trimming back.

P.S.: Thank you for reading. I would very much appreciate your inputs, reactions and constructive feedback.

Disclosure: I am/we are long IBM.