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IBM - What should investors expect from their investments in tech

I confess that I have different standards than some writers on this site about what I expect from my investments. For the most part, I think investing in IT is all about growth - at some price or the other. There are names that feature growth at a reasonable price and there are names that feature hyper growth. Finally, there are IT vendors who pay significant dividends and are considered to be value names. I get that, although I rarely choose to invest in such names. But what I insist upon, overall, is some level of transparency, some level of reasonable self - evaluation and some level of market share maintenance. I do not see much of any of that in IBM (NYSE:IBM). It pleases some investors because of its dividend and its cash flow. It simply doesn't make my cut because of its self-evident problems in evolving a strategy that might allow it to grow at a rate consistent with the market or to articulate a strategy to improve its execution. I think it is unfortunate - and I could think of other terms to use - to own a position in a company that can't at least demonstrate some kind of plan to maintain its market share or to discuss its glaring issues with some level of candor. And I think it is unfortunate for investors to conclude that IBM's long series of quarters of shrinking revenues has really come to some kind of conclusion. It is very far from the case.

Last week, two very different tech companies reported. One of those, and the subject of this article, was IBM. The other was Atlassian (TEAM) - more or less the antipode in terms of its investment features. Some commentators on this site felt that IBM's quarter was good enough, and obviously the preponderance of sentiment has been that Atlassian's quarter was not good enough. My view is that those conclusions, whether they bear out this day, or next week, are exactly wrong. IBM had a relatively weak quarter, bolstered by FX and bolstered by a mainframe cycle. Atlassian - well I will take up Atlassian in a different note, but suffice to say it is rare to see many companies of its scale show accelerating growth and substantial improvements in cash flow.

There are, self-evidently, contrary views some of which have been expressed on this site and others which have been expressed by covering analysts. But it would be very difficult, to take this quarter in context, which is what is required to come to an appropriate conclusion, and reach a conclusion other than that IBM has serious issues, some of which are being masked by FX, some of which are being masked by a mainframe cycle of some significance and all of which depend on the very benign climate for IT spending.

Yes, IBM's strategic imperative revenue bucket grew more rapidly this quarter than in the prior quarter. But that not that much faster and it did so at the expense of IBM's legacy business which slumped at a faster rate than in the past. And yes, IBM improved its cash flow performance. But IBM continues to hemorrhage market share where it counts, in strategic imperatives and elsewhere. And losing market share is not part of a recipe for investment success over any time period. IBM shares, before Friday's setback, have been up 12% since late December. Presumably that reflected optimism regarding the demand environment, FX and perhaps other factors. While IBM shares slipped by 4% on Friday, that was really a very modest reaction after a period of strong performance to a disappointing quarter that left many more positive observers scratching their heads. Investors should take a deep breath, search their souls, and find another ship besides IBM on which to sail.

A Careful Analysis of What IBM Reported

Sometimes, in the heat of the moment, investors can easily lose sight about what is important, why it is important and what it portends. The issues of IBM's forward tax rate, its one-time charge relating to the tax reform legislation and even its margins are less important to me, than the ability of this company to sell what it has on offer.

Let's start by looking at revenue. IBM grew its revenue by 1% in constant currency and 4% as reported. Better for sure than the published consensus, but how much of the published consensus included currency gains? Not much, I imagine.

Whether it is 4% or 1%, the fact remains, IBM is simply not getting its wallet share of customer spending. I invest and analyze tech stocks for a living. Many commentators who are more familiar with the analysis of income equities appear to be unfamiliar with the significance of market share in analyzing how a company is doing in the tech world. At the moment, there is a pronounced rising tide in tech spending. And it is helping almost all boats. But a far better way of looking at IBM's revenue performance, rather than considering the headlines about the company breaking its streak of 22 quarters of decline, is to look at how it stacks up in terms of market share. And that analysis is considerably less positive than just celebrating the end of a nasty streak of negative revenue comparisons.

IBM reports results in 5 major buckets. These include Cognitive Solutions, Global Business Services, Technology Services and Cloud Platforms, Hardware Systems and Financing. I will briefly discuss the revenue trends in the first 4 buckets; overall 3 out of the four are still showing poor performance and that performance actually deteriorated some more in the just reported quarter.

Cognitive Solutions were 24% of company revenues this past quarter. Even with positive trends in the security and transaction processing components of this space, Cognitive Solutions was flat on a constant currency basis. The performance of Cognitive Solutions was worse and not better in Q4 than Q3 when it actually grew by 3% on a constant currency basis. The enterprise software business has been exceptionally strong these past 90 days - and yet IBM's comparisons on a constant currency basis have deteriorated. Those who want to spin this quarter as one of positive attainment need to understand just what is actually happening in IBM's software business.

The second bucket in which IBM reports is Global Business Services, or its consulting and application management offering. Overall, Revenues in Global Business Services fell 2% on a constant currency basis. That 2% decline in constant currency is comparable to the decline seen in Q3. The strategic imperative component of GBS actually did marginally worse in Q4 than in Q3. But more concerning to me, is that while GBS is still declining, competitors in this space such as Tata, (TTM) and Infosys (INFY) are growing at 6% on a constant currency basis and are reporting exceptional growth in digital transformation deals. One may well wonder, where is IBM, and why is it not getting a piece of this action? Looking to management commentary, one would have no idea that the company is struggling competitively.

Technology Services and Cloud Platforms which includes infrastructure offerings, maintenance and integration software fell by 1% in constant currency during the quarter. This revenue bucket represents 40.8% of total corporate revenues. The 1% decline in revenues is better than Q3 results when that bucket fell by 4% - but a decline is hardly a comfortable attainment in a bucket that includes so many high-growth areas. This is the bucket that includes IBM cloud service, mobility solutions and security. Those items grew by 15% last quarter, dramatically less than peer competitors in the space and just further highlighting how weak the balance of this revenue category remains.

Finally, IBM's Systems business, which is basically mainframe and storage hardware showed strong performance. Revenues rose 28% in constant currency year on year and were driven by the IBM Z product cycle and by IBM's emergence as a significant competitor in the flash storage space. This growth compares to a 10% improvement in Q3. IBM's system business is less than 15% of revenues.

Absent the systems business, which is enjoying an unsustainable boost from the company's product cycle, revenue performance deteriorated this quarter compared to last quarter and the company's non-hardware business contracted at about 1%. Hardware comparisons will become difficult starting in Q3 of 2018 and obviously will be hard to maintain at current levels when IBM reports Q4 2018 results. There is still nothing at hand that suggests that IBM is returning to sustainable top - line growth.

The Mythology of Strategic Imperatives

As many readers know, IBM reports its revenues both in multiple buckets but also slices those buckets between what it calls strategic imperatives and everything else - essentially legacy solutions. Last quarter, strategic imperatives represented 46% of revenues and grew by 14%. This was a noticeable improvement from the 10% growth the company reported in Q3 in this revenue category, and from the 11% growth reported for the year. Many commentators are mesmerized by this kind of reporting.

IBM now calls itself a cognitive solutions and cloud platform company. Of course, marketing is a central element of IT sales - but has IBM really made the pivot it now suggests in its title? Some commentators on this site continue to believe that the way forward for IBM will be paved by strategic imperatives. Is that possibly true? Strategic imperatives include 5 buckets of its own, although one of the buckets, cloud is divided as well. Looking a bit further might disturb some perpetual optimists. The results last quarter bear careful investigation. I am not going to try to investigate every nook and cranny here - just suggest that the numbers suggest a result far less benign than the headlines might indicate.

As mentioned, Cognitive Solutions is a crucial element of IBM's portfolio. It has very high gross margins - double or more the gross margins of IBM's other revenue buckets. And selling software can often be the key that IBM can use to unlock large consulting and system management assignments. It is perhaps, too much to say that it goes, so goes IBM, but it is one place to look for a successful turnaround. And it is certainly one of the place to look to see the success of strategic imperatives.

But in Q4, strategic imperative revenue within Cognitive solutions fell by 3% and cloud revenues increased by all of 6% on a constant currency basis. That is actually quite a bit worse than the growth rates that IBM achieved in those categories in Q3 when strategic imperative growth was a positive 5% in Cognitive Solutions and cloud growth was 10% in that category.

Why focus on that? Because it suggests that IBM continues to have a tough time trying to sell its software products, on which it achieves far greater margins than its services. This hasn't changed despite all of the representations of IBM's transformation. If IBM is really making a successful pivot, this is where one should expect to see results. These results suggest that IBM's sales machine is corroded and simply not up to the task of delivering reasonable quarterly execution or that its products are nowhere near as competitive as they need to be.

IBM offers a plethora of support services to its clients. Most people think of what is offered as consulting, integration, creation of cloud capabilities for clients and outsourcing of various kinds. IBM has tried to reignite growth in these sectors - mainly inorganically. The effort doesn't seem to be succeeding. This isn't what IBM's management said during the course of the conference call but it is what the numbers suggest to me. First of all, every company that sell consulting services these days is pivoting to the cloud and to offering digital transformations. That is what users want to buy. At the end of the day, it would not seem as though that shift in demand has really helped IBM to achieve faster revenue growth.

For example, when I look at strategic imperatives within consulting, constant currency growth was 11% in Q3 and it was 7% within Q4. Try as one might, that simply doesn't square with an improving outlook for consulting revenue. Overall, Q4 services signings were $13.7 billion, down 10% on a year on year basis with a services backlog of $121 billion, down 3% year on year. Those results are better in absolute dollar terms than Q3 results, but in Q3, signings grew by 15% and backlog fell by 2%. Again, there is simply nothing substantive to point to that might suggest that IBM's consulting/system management business is improving.

The composition of IBM's consulting business is changing to be sure in that it is more cloud and more digital. And it is changing to incorporate some of newer technologies such as AI and Block Chain. But it isn't growing - and in fact without 7 acquisitions in the past year, it is continuing to shrink. And it is certainly not achieving market share gains. Try as one might to come to a different conclusion, IBM continues to lose market share each and every quarter, both to Indian firms such as Cognizant (CTSH) but also to Infosys and Tata and to American consultancies as well such as Accenture (ACN) and the newly formatted DXC Technologies (DXC). They all offer AI and Block Chain solutions, they are all focused on selling to users who engage them to manage digital transformations, and they are focused on providing their customers with cybersecurity, big data and IoT solutions. The major difference is that almost everyone in the space is doing a better job in these areas in terms of translating this demand into actual profitable growth.

The real reason why strategic imperatives and cloud showed relatively robust growth last quarter has nothing to do with IBM's pivots and everything to do with the success of IBM's mainframe cycle. IBM's Z system achieved 71% growth last quarter compared to 62% in the prior quarter. New Z Systems are being delivered with pervasive encryption, they are being used to support hybrid cloud architectures, and they are being used to support Blockchain solutions. And so, one finds that as IBM reports strategic imperatives, that metric within systems has shown a 91% increase compared to a 25% increase the prior quarter, while cloud growth which is part of strategic imperatives, showed an 86% rise this past quarter up from 23% in Q3. Right now, the mainframe performance is above the prior cycle (z13) and consistent with the z12 cycle a few years ago.

And IBM has enjoyed some reasonable success with its all-flash arrays in the storage business. Further, the company's superscalar offering Power9 is having success and as many of its workloads are used for AI, its revenues get counted as part of strategic initiatives. But should investors count on a mainframe cycle and a high-performance computer cycle in making a long-term investment decision regarding IBM shares? IBM management has suggested that some of the innovations in the current product range including blockchain, cryptography, security and reliability will make this cycle different, and perhaps longer, then other cycles. The length of the mainframe cycles is a crucial component in management's earnings estimate. It needs to continue at elevated levels at least for another couple of quarters. While that is probably more likely than not, is it really prudent to base an investment judgement on the length of a mainframe cycle.

I think that when one gets down in the details of the numbers that were released, and compares those numbers to the results of Q3, they simply do not support the contention that IBM's pivot to strategic initiatives is producing the kind of results that are embodied in the more positive commentary about prospects for the company.

Margins

There is just no getting around the fact that reported margins for IBM showed ugly trends last quarter and were quite a bit below levels management had projected on its last earnings conference call. Most of my comments will relate to GAAP based numbers. In addition, IBM has pronounced Q4 seasonality which makes comparisons with Q3 not valuable, for the most part in an analytical framework. Overall, Gross margins fell in all of the buckets for which IBM reports that metric.

The steepest fall in terms of gross margins was in Cognitive Solutions - mainly software - where gross margins fell by 350 basis points to 79.2%. Management attributed some of the fall due to underperformance in its sales of content management and integration software specifically, and due to its inability, in general, to close larger "transactional" deals. In other words, the company missed its targets.

Consulting gross margins, lumping everything in that area together, fell 200 basis points. The explanations offered by the duet of the CFO's on the call really don't deserve exposition. Blaming currency fluctuations for a fall in gross margins is simply not credible. More likely is that IBM is recognizing the results of some bad deals that it booked somewhat earlier in the cycle and which may not have been properly planned or understood by management earlier in 2017. Management says that these anomalies will not persist. It has embodied some level of recovery of recovery in gross margins as part of its forward guidance, and judging by questions during the conference call, one that seems most problematic to observers and this writer.

IBM also actually saw a decline in gross margins within systems, although it did improve its hardware margins narrowly. I am not quite sure, after parsing explanations offered, precisely why IBM thinks gross margins for systems were so weak. Notionally, a robust performance in selling its Z series, coupled with satisfactory performance in other hardware products should have produced a far greater upside. This is a case of the glass being half full and leaves me speculating that margins in systems might show significant upside going forward as the mainframe cycle enhances.

IBM had a mainly satisfactory performance in its operating expenses. On a constant currency basis, selling, general and administrative costs fell by about 100 basis points and research and development expenses fell by 500 basis points. Given the company's sales performance - or lack thereof - the fall in selling expense is reasonable. It is more difficult to analyze whether the company can afford to reduce development spend. IBM needs to spend as much as it can prudently to improve its competitive performance and as an outsider, I have no way of gauging prudence. The sales of IP, which carry 100% margins fell significantly in the quarter and caused the reported operating expense bucket to rise.

Management was more than a bit muddy when it came to forecasting opex over the coming year. Overall, I think it will probably rise a bit, not including IP sales which is not a metric that can be readily forecast. That is as much of a guess as anything else. Management simply waffled on the issue although how it will be able to maintain EPS with a higher tax rate without improving opex ratios is difficult to see at this point.

Valuation

I think that IBM will be able to show growth in this current year based on the strength of the mainframe cycle, based on currency and based on an improving backdrop for IT spending. It is difficult, at least from the conference call to understand IBM's external expectations. The scenario that IBM has pivoted is one I find hard to credit but I also think that cyclical factors + currency are significant tailwinds.

Can IBM achieve its earnings goal with dramatically greater tax rate accruals? If there were a poll, I would say it could. As management said on the call, it has lots of levers to achieve that result, although whether IBM earns $13.80 or $13.79 really doesn't matter much to me in framing an investment opinion. For several years now, when IBM has been on the edge, in terms of reported headline EPS, it has managed to deliver headline numbers because of tax rate improvements or IP sales or some other factor and that is what I anticipate will happen this year. It is about the same as betting on the Patriots down 10 in the 4^th quarter. Somehow, Brady and his colleagues get it done and afterwards you do not quite know how.

IBM is valued at modest EV/S and P/E metrics because it is not growing and with the pivot in its 5 year or so, there are simply no objective signs of a return to growth on a long-term sustainable basis. Most investors value IBM for its cash flow and its ability to return capital to shareholders based on that cash flow. The company is forecasting that free cash flow will decline about 10% this year. Some of that is because of an increase in CapEx. Some of it relates to the balance sheet where this year's improvement cannot likely be reprised, and some of it relates to cash tax payments.

IBM has a current market cap of $151 billion. It has net debt of about $29 billion and that leads to an enterprise value of $180 billion. The projected free cash flow yield of 6.7% is very unimpressive to me, given the company's inability to grow.

I do imagine, that regardless of the decline forecast in free cash flow, the company will increase its dividend by a modest percentage this spring. I imagine that it will continue at its current cadence in terms of share repurchase which will consume about a little more than 1/3rd of its free cash flow. IBM has been relatively restrained on the merger and acquisition front lately. I think the company has many holes in its offering, but whether or not it makes a significant strategic acquisition this year is unknowable.

Over the past year, IBM shares have lost about 6% of their value and have underperformed the tech index quite dramatically. The underperformance may be less this year, but there is nothing I see in the outlook that might lead to any positive alpha.

This article was written by

Bert Hochfeld graduated with a degree in economics from the University of Pennsylvania and received an MBA from Harvard. Mr. Hochfeld has enjoyed a long career in the tech world, working for IBM, Memorex/Telex, Raytheon Data Systems, and BMC Software. Starting in the 1990s, Mr. Hochfeld worked as a sell-side analyst and won awards from the Wall Street Journal for his coverage of the software space. In 2001, Mr. Hochfeld formed his own independent research company, Hochfeld Independent Research Group, which provided research services to major institutions including Fidelity, Columbia Asset, SAC Capital, and many other prominent institutions and hedge funds. He also operated the Hepplewhite Fund, a hedge fund that specialized in technology investments. Hedge Fund Research, an independent 3rd party firm that specializes in ranking managers, rated the Hepplewhite Fund as the best performing small-cap fund for the 5 years ending in 2011. In 2012, Mr. Hochfeld was convicted of misappropriating funds from a hedge fund he operated. Mr. Hochfeld has published more than 500 articles on Seeking Alpha, all dealing with companies in the information technology space. Highly esteemed for his investment wisdom accumulated over decades, Mr. Hochfeld ranks in the top 0.1% of Tip Ranks analysts for his selection of information technology stocks and their subsequent successes.

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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Source: https://seekingalpha.com/article/4139322-ibm-sad-tale-of-underperformance-continues

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