IBM

IBM (IBM) continues to perform poorly as the growth declines and margin increases have come to a halt. The company has failed to grow over the last 10 years, as cheaper and nimbler competitors from India such as Infosys (INFY), Cognizant (CTSH) etc. have taken away marketshare in IT services. The company continued to show increased earnings shares by massive buybacks and by hiring low cost workers in India. It’s divestment of the low margin hardware division also helped the company increase its overall profitability. The company now faces a huge growth challenge, as most of its cash flow generating levers have been exhausted. IBM also has a higher debt equity ratio compared to other large technology companies. The software industry is also at an inflection point as increased automation and cloud computing is changing the dynamics of the industry. New competitors such as Amazon (AMZN), Google (GOOG) etc. have started entering IBM’s area of providing IT software. The company is making belated attempt to catch up to the newer technology areas such as Social Media, Analytics, Mobile computing, however it is late to the party. At best, it will be another competitor in a crowded field. I have been consistently negative on IBM for some time and its current quarterly results have not changed my views. The stock has heavily underperformed the NASDAQ, as investors look towards faster growing companies.

Another quarter of falling revenues                      

IBM kept up its dismal track record of declining revenues for the 12^th consecutive quarter. This shows that the company is in a serious long term decline. It needs some serious turnaround measures and a radical change in its business strategy and focus. The technology industry is extremely dynamic and trends change rapidly. Companies which cannot adapt and stay ahead of the curve, can rapidly become irrelevant at best and extinct at worst. IBM’s strategy of focusing on software and services is long past its sale by value. Other technology companies such as Xerox (XRX), Hewlett Packard (HPQ) and Dell have adopted similar strategies. There is increasing competition in this space and it will be tough for IBM to increase its revenues and profits in a more crowded segment. The company has forecast earnings of ~$15 with flat free cash flow generation. This means more stagnation for investors.

Most geographic segments and business divisions declined

IBM’s revenue decline in almost all geographic regions shows that the company’s overall competitiveness continues to decline. I could understand revenues falling in one or two regions, but IBM has managed to show declines in all regions. The management has defended itself by saying that declines came in divisions which have been sold off, otherwise they would have been flat. But flat is not good enough for investors. Revenues fell by 12% y/y to $19.6 billion. Technology services fell by 10%, business services by 13% and software by 8%.

Falling behind competitors

IBM has failed to compete with major IT services players both over the short and long term. Despite imitating Indian IT companies in hiring cheap India software workers, IBM has failed to match their high double digit growth rates. Even as the Indian industry is forecasting growth of 12-14% this year, IBM will be struggling to grow at all. Even US based competitors such as Accenture (ACN) have performed much better than IBM. Some analysts support IBM because of its presence in providing high end services such as business consulting to clients. However, IBM cannot compete with large consultancies such as Accenture, PWC etc. and is known mostly for providing IT consulting services.

Margins have flattened out

IBM has been able to offset the decline in revenues over the years with increase in margins. However, the rate of margin growth has started to flatten out, as most of the levers such as outsourcing and selling the hardware portions of the business have played out. I don’t think the margins can increase much further from here. Combined with flattening revenues, this means that earnings will also stagnate.

Other troubling issues

IBM has a huge amount of debt (more than $38 billion), which the company has mainly used to fund dividends in the past. This means that the company’s options in terms of doing a large acquisition or investing in new areas is limited. They will also be hard pressed to use their low valued stock to buy other companies. The company is also getting hurt by the stronger dollar. I don’t think that the dollar will become weak anytime, given the major structural issues with China, Europe and Japan.

Upsides Risks

a) Valuations are not expensive – IBM has been stuck in the $150-200 range for some time now, even as the other bigger technology companies have seen their stock prices go up substantially with a rally in the broader markets. Without the low interest rate environment, I would have expected IBM to be much lower than what it is today. The company’s valuation is not expensive, with a forward P/E of around 10x and a dividend yield of ~3%. On the downside, the company has a lot of debt with a debt equity ratio of 2.8x compared to 1x for the industry. IBM has funded a lot of buybacks and dividends in the past through debt. I don’t think a utility investor is going to invest in IBM. The technology industry is much more volatile than utilities, where investors look for stability of cash flows and dividends. Growth investors will also look to avoid IBM for its complete lack of growth.

b) Getting traction in the cloud business – IBM reported that its cloud business has grown substantially to a $3.8 bb annual business. IBM has been really late to the cloud party and allowed non-services companies to become big players in this area. IBM is managing to grow the cloud business because of the overall high growth of the industry. Microsoft (MSFT), Amazon (AMZN) and others are all growing their cloud divisions rapidly due to the inherent advantages of cloud computing (lower costs, faster upgrades, less inventory). But cloud computing is still less than 5% of IBM’s total revenues and it is difficult to see how cloud computing can alone pull IBM out of the morass that it has gotten into.

Summary

IBM has been a dead investment for a while and the stock price has stagnated in a range. Given the company’s deteriorating fundamentals, the probability of the stock falling below the range is greater than breaking the range on the upside. The company’s revenues continue to decline, margins have flattened out and it is losing market share to competition. There is some progress in new technology areas, but all major companies are managing to grow their cloud computing divisions. The valuation is not high as per traditional valuation metrics, but given its poor growth prospects it is probably on the higher side. I don’t see the management making any major changes to its strategy to get out of its predicament. The company raised its dividend, but that was at the cost of buybacks. The company’s strategy of squeezing wages by outsourcing workers has no more legs. I think IBM remains a high conviction sell candidate.