IBM: How Long Until I Should Throw In The Towel? – International Business Machines Corporation (NYSE:IBM)

I guess at this point I shouldn’t be surprised to say this, but International Business Machines (NYSE:IBM) has failed to grow its quarterly revenues again. Q2’s decline marks the 21st consecutive quarter that IBM has posted falling sales figures. This is a pretty damning streak. I would assume that at some point during the previous five years of restructuring that lowered y/y comparables would have enabled IBM to post a top-line beat of some sort…once or twice, at least. In the age of activist investors, it’s really remarkable that a company of this size and prestige has been allowed to struggle for so long. I own a very small position in IBM that I purchased years ago. I’m under water, and while I’m concerned about this company’s future, I’ve had a hard time justifying locking in the loss while the company pays me such a nice yield. However, I can’t help but wonder if this stock isn’t in a secular decline.

Sometimes I look at IBM’s shares and their nearly 4% yield and think that they’re undervalued and should be bought, if nothing more, as a bond-like equivalent with income growth potential. And other times, I look at my shares and wonder if parting ways with the company wouldn’t be in my best interest; sometimes throwing in the towel is the best course of action when you know you’re beat. At this point, it seems pretty clear to me that IBM is significantly behind its competitors in the areas of meaningful growth that it has chosen to pursue. I go back and forth on this often, usually coming to the conclusion that I will kick the can down the road until the next earnings release, hoping that it will be the breakthrough quarter in terms of sales growth. Thankfully, my IBM position isn’t a large one, so either way, my decision (or lack thereof) doesn’t have a great effect on my portfolio. In this piece, I will continue to discuss the pros and cons of an investment in IBM. As always, I look forward to your input in the comment section as I attempt to come to a conclusion on this admittedly perplexing name.

Q2 Breakdown

So, first thing’s first…let’s take a quick look at the Q2 numbers. IBM posted revenue of $19.29b, which missed analyst expectations by $160m and was down 4.7% from last year’s Q2. This 4.7% drop is significant.

On the bright side, IBM did beat analyst estimates on the top line, posting EPS of $2.97 (this is the non-GAAP figure; the GAAP EPS was much lower, at $2.48). The $0.23 beat was also significant. However, when you read deeper into the results, it becomes clear that a large portion of this beat was due to a discrete tax benefit that boosted Q2’s EPS by $0.18, meaning that the true beat was more like a nickel instead of a quarter. I think the company’s accountants should be applauded for this result in the short-term. However, I don’t think the 4.5% tax rate that the company paid in Q2 is sustainable.

Furthermore, even after this large (somewhat fabricated) bottom-line beat, IBM didn’t raise its full-year guidance, seemingly signaling that the back half of the year could be soft with slowing growth canceling out the tax-related gains. This is disappointing to me.

When looking at IBM’s results, the first thing that I do is look at the business segments to see how the new age cloud/cognitive solutions growth stacked up against previous quarters. IBM’s strategic imperatives have grown to the point where they represent ~43% of the company’s sales. This is a positive, but I don’t think we’ll reach a tipping point in terms of growth until these higher growth areas make up a majority of the company’s top line. Cloud revenue now makes up ~20% of IBM’s sales. This too is a positive. IBM posted a solid 15% growth in the cloud space, but the growth of its sequential exit run rate slowed drastically in Q2 – to 32% from 61% in Q1 (these figures are adjusted for currency). I’m not sure if this company can afford to post slowing growth in the cloud space quite yet. There are simply too many strong competitors looking to take market share for IBM to give up ground, especially when management thinks that we’re still in the early stages of cloud adoption.

But it wasn’t the slowing sequential run rate that bothered me the most about this quarter’s results. Probably the most worrisome aspect of Q2 for me was the fact that the company’s operating margins fell 2.3% to 45.6%. This is a significant drop, especially with the management team harping on profits as opposed to sales. If the primary focus of this company is profits (more on this in a bit), I wouldn’t have expected to see the margins fall. I worry that this points towards a secular demand issue for IBM’s products/services. The declining sales have shown this for years, but it wasn’t until 2016 that the margins began to reflect weakness. If this trend continues, then I think this stock is really in trouble and we will likely continue to see new lows.

2012 2013 2014 2015 2016
Gross Margin 48.10% 48.60% 50% 49.80% 47.90%
Net Margin 15.90% 16.50% 13.00% 16.10% 14.90%
Operating Margin 19.60% 18.80% 19.20% 19.20% 16.40%

For IBM to turn the corner and return to growth, I think we’re going to have to see the strategic imperative segments making up the lion’s share of the company’s sales. The legacy services and systems divisions are nice cash flow generators for this company, but over the long term, I suspect their margins will decrease as demand/sales fall. At the end of the day, IBM needs its AI/Cloud business to take over. This transition is taking much longer than I thought it would. This behemoth has surely been slow to evolve, allowing its competitors to take share. With so many large, powerful players operating in the cloud space, I expect the competition to remain cutthroat. I think the cloud market is big enough for several competitors to co-exist while maintaining hefty margins, but there probably isn’t enough room for everyone to thrive. I don’t think IBM is ready to resign itself to being a small, niche player. I don’t think the game is over yet. I’m willing to be patient with this company because of the income it produces for my portfolio, but at the end of the day, revenue cannot decline indefinitely without harming the balance sheet and eventually impairing the company’s ability to sustainably pay the dividend. We’re not at that point in time yet, but every quarterly sales decline leads IBM closer to dire straits.

A Focus On Profits

Before, I mentioned that IBM’s management team made it clear that the company’s focus was on profits. CFO Martin Schroeter talked about this in the conference call as well as in an interview on CNBC after the earnings release. Here’s a link to the interview.

Schroeter spoke about the company having a “high value model” and focusing on finding “profit pools” within the enterprise software space rather than chasing revenues. He continued, saying that the company is “shifting its business” towards those “profit pools” because while “it’s easy to get revenue in an enterprise space, it’s finding the profit that we’re focused on.”

Now, this profit-centric talk sounds fine and dandy; ultimately, generating profits is what running a business is all about. It’s these profits that have enabled IBM to be so generous towards shareholders, which you won’t see me complaining about. But I can’t help but wonder if this “profit pool” focused rhetoric is simply another PR game that IBM is playing, because if it were truly “easy to get revenue,” then why has the company failed to grow its top line sales for 21 consecutive quarters (more than five years!)?

To me, it sounds disingenuous to say that something is easy to do when you’re unable to achieve it – the market would absolutely love IBM to return to sales growth, so it’s not as if shunning top-line growth is a strategy that management has actively pursued. No one would do this, especially in a world where companies like Amazon (NASDAQ:AMZN) and Netflix (NASDAQ:NFLX) demand sky high premiums in the market, having convinced investors that taking market share and building a user base is more important than generating profits (for the time being at least). The market has bought into this economy of scale thesis and what IBM is doing seems to be on the opposite end of the spectrum. Whether you agree or not, the market speaks for itself and I doubt any management team in the tech space right now would rather pursue a business plan that results in IBM-like multiples as opposed to the AMZN/NFLX-type premiums.

I understand that the IBM management is essentially making a sales pitch to investors during the post earnings commentary, but I was also put off by the fact that Schroeter highlighted the additions of large companies like American Airlines (NASDAQ:AAL), Bombardier (OTCQX:BDRBF), and Lloyds Bank (NYSE:LYG) to the IBM cloud, but conveniently disregarded the fact that it lost business from a mega-player like Facebook’s (NASDAQ:FB) WhatsApp. To me, when reading through the ER and the CC, I saw a lot of fluff. I don’t blame management; it needs to spin this 21 quarterly streak of falling revenues as nicely as it can. But when the chinks in your armor are so large, it becomes easy to see through them.

When reading/listening to all of the post-ER commentary, the phrase, “putting lipstick on a pig” came to mind. I don’t necessarily blame IBM’s management team for an attempt at a positive spin, but at the end of the day, it was difficult for me to be excited about this news as a shareholder.

The Dividend

Now, all this negativity aside, there is one positive aspect of a falling sales price: the opportunity to buy shares with a higher yield on cost. To me, IBM’s dividend is the primary reason to own the stock at this point. I have no idea when IBM will return to top-line growth, but I am confident that the dividend is sustainable in the short-medium terms, and if an investor believes that the company will eventually figure out the transition to a cloud/services oriented, these depressed prices could represent a solid, long-term buying opportunity.

When looking at dividend sustainability, the two main fundamental metrics that I track are EPS and FCF/share. As you can see below, IBM’s dividend remains well covered by both of these metrics:

2012 2013 2014 2015 2016
EPS $14.37 $14.94 $11.90 $13.42 $12.38
FCF/Share $12.87 $11.80 $12.64 $13.82 $15.02
Dividend $3.30 $3.70 $4.25 $5.00 $5.50

The problem that many investors have with IBM is the fact that the company’s reduced share count via buybacks are responsible for much of this EPS/FCF/share rather than strong organic growth. I don’t mind the fact that IBM buys back shares. The company certainly doesn’t trade at an expensive multiple and management has done a good job of reducing the share count over the years (and not just using cash to buying back shares that it plays on later rewarding to management in a dilutive fashion). However, coming back to the slumping sales and falling margins, if IBM isn’t able to return to growth, its shareholder returns will inevitably slow and without the constant share count reduction, this company’s bottom line won’t look quite as nice. In Q2, IBM’s free cash flow was $2.6b.

2012 2013 2014 2015 2016
Outstanding Shares 1,054,391 990,524 965,729 945,867 939,497

The company returned $1.4b to shareholders in the form of the dividend and another $1.4b in the form of buybacks. This means that shareholder returns were greater than free cash flow during the quarter. This is not a sustainable practice, and in the absence of growth, it likely means that buybacks will have to be reduced moving forward (because I don’t see management cutting the dividend in favor of buybacks).

Conclusion

With the Mayweather vs. McGregor fight on the horizon, I decided to use the boxing analogy for this article’s title. As shown in this piece, there are pros and cons to owning IBM at the moment. Admittedly, I’m seeing more negatives than positives, but since I’m currently underwater on my shares (my cost basis is $181), I’m willing to look past these and focus on the dividend and the value that the stock presents at the moment. With that said, I can’t help but wonder how many more rounds (quarters) I’ll be willing to stick this one out.

I’ve owned IBM for years and I’ve been more than happy with the income that it has generated. However, I do have concerns that IBM has turned into a secular short and has a floor much lower than the $147 share prices that we’re seeing today. I think that the company’s 4.1% dividend yield will help to insulate shares from further downside. I’m sure that I’m not the only one who, while disappointed with the stock’s performance, appreciates a 4% yield and believes that IBM’s dividend is more than safe moving forward. As I said before, this isn’t a high growth company anymore, but at a certain point the company becomes a conservative store of wealth for those interested in the yield. But, at the end of the day, this 4.1% yield will mean very little if the stock sees another 20% of downside. Over time, fundamentals will rule the day, and if IBM can’t produce higher sales, higher margins, and higher EPS, over time the share price will continue to erode.

What do you think? Has this most recent quarter changed your tune on IBM at all? Are you more or less bullish on the company’s strategic imperatives transition? Are you buying shares on this weakness?

When Warren Buffett sold shares recently, it made big news, but he sold those shares at ~$180. At a certain point, the value IBM presents, even in the face of current sales issues, will be intriguing. Now I’m just trying to figure out if that is at $145, $125, or $100. It’s difficult to evaluate a company that is potentially in the midst of a secular decline. Where are you placing fair value on shares?

Disclosure: I am/we are long IBM, AMZN.

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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