IBM, Cheap for a Reason

IBM, Cheap for a Reason

International Business Machines has built a tremendous business selling big iron over decades. It survived the shift to client server computing, numerous recessions, and management changes. Now it seems to be competing with its history from an investment standpoint. In order to meet massive earnings hurdles, the company went bigger by adding professional services and even financed the projects to enable the customer to absorb huge price tags! How big can it get? In the December quarter, IBM generated $28 billion in revenue. This is more than double the annual revenue of customers like Avon Products which generated $11 billion in its most recent fiscal year. Can this continue?

In December the Wall Street Journal reported that the Avon implementation failed to meet its global roll out schedule and would result in a $100 to $125 million writedown. In the article, the SAP representative hinted at implementation problems being the culprit and IBM was the implementation partner. These deals are the bread and butter for IBM which supplies the hardware, middleware, and project management services.

SAP is known for having very rigid software that requires changes in business processes rather than modifying the software. As an example, as late as 1999, the company had database table names in German up and running at United States Fortune 500 companies. It is critical for the integrator to use its global business knowledge to find a middle ground between established business practices and difficult software revisions.

On Tuesday, IBM beat earnings expectations by $0.13 for the quarter, but missed on revenues and guided fiscal 2014 earnings per share in line. Revenues of $27.7 billion were down 5.5% year over year. Earnings of $6.13 beat the $6.00 consensus estimate, but guidance of $18.00 for 2014 was just in line with expectations. Consequently the stock sold off by nearly 4%.

Hardware was blamed for the sell-off but that understates the problem.
IBM offers a detailed revenue breakout with gross margins for each line of business. Its easy to see that revenue from "Systems and Technology" are down as many news sources have reported. Systems and Technology revenues were $4.2 billion, down 26% year over year.

Hardware really isn't that big a contributor to profits anymore though. This segment has seen negative growth each quarter in 2013 and had a difficult comparison against fourth quarter 2012 revenues. If you look at the underlying numbers, Systems and Technology only accounts for 15% of revenue and gross profit.

What needs to be addressed though is the flow through to other businesses. While middleware is the largest component of software, operating systems are also a component, and mainframe operating systems aren't free. The hardware business also drives the project integration opportunities in Global Technology Services. The important thing here is that each of these businesses contributes more to revenue and has higher margins than Systems and Technology. Combined Software and Services account for 84% of the revenue and over 90% of the gross profit.

Services could cause another drop in estimates.
If the slowing Systems and Technology business is a leading indicator for implementation services then 2014 will be a tough year for IBM. Global Technology Services has a margin in the high 30's, much lower than Software's stable 88%, but a major contributor to $18.00 per share in earnings. Today this business is declining in single digits but if failed packaged software implementations lead to double digit declines, it would not take much for today's earnings goals to seem lofty.

Management is not sitting idly by.
IBM's management reacted by eliminating bonuses and selling the low-end server business to Lenovo ; it is divesting a business that was likely a drag on both revenue and profitability. Lenovo has the low cost operating structure resulting from lower cost labor, this is needed to compete in the dog eat dog consumer and small enterprise hardware market. Sustained negative growth is a cancer for public companies and in the case of IBM's commodity hardware business, it has few choices: Take the business private, as was the case with Dell, or sell out to a low cost producer. Either is better than competing over pennies with a low-cost producer.

What is the investment thesis for IBM? IBM may no longer be a growth stock but it is cheap on a relative P/E basis to the S&P 500. Currently, IBM is at 12 times trailing twelve month earnings while the S&P 500 is at 19.5 times. IBM's dividend yield of 2% is comparable to the S&P's of 1.9%. If you believe that hardware was the key issue then the stock is cheap at current levels, but if you believe there is another leg down for revenue growth to fall, you may want to wait.

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