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IBM shares have fallen 7% so far this year and are down 34% from their peak of nearly $216 reached in early 2013. Over this same five-year period, the S&P500 Index rose nearly 20%.
The underperformance is even more stark since January 1, 2012, when current chairman, president and CEO Ginni Rometty took the helm. IBM’s shares have been trimmed by 23% while the S&P500 Index has more than doubled, increasing just over 115%.
One big problem: revenue growth rate is zero, at best
IBM yearns for investors to view it as a “growth” company. No doubt the company has a strong positioning in emerging technologies like cloud computing, blockchain and artificial intelligence. But even with these boosters, supplemented by acquisitions and its enduring mainframe franchise, the company continues to struggle for any revenue growth.
Following its legendary 22 consecutive quarters of declining revenues, IBM has produced two consecutive quarters of growth, with the most recent quarter’s 5% growth actually accelerating from the 4% rate in the prior period. Yet, when volatile currency changes are removed, that otherwise impressive 5% growth rate evaporates to zero.
While uninspiring, flat revenue growth may seem acceptable a year from now. IBM’s mainframe product line, a near-monopoly that is renowned for its reliability, security and speed, is experiencing dramatic growth thanks to an impressive upgrade cycle. Now nine months along, this cycle won’t last forever, and will likely produce a revenue hangover when it winds down.
On a longer-term basis, during Rometty’s tenure1 across six full calendar years, revenues have declined an unnerving 26%. While sizeable divestitures, including the sale of its semiconductor business to Global Foundries in 2015 and its x86 server business to Lenovo in 2014, contributed to an annualized $7 billion of divested revenues in the past five years2, they hardly account for the $27.8 billion in total revenues lost since 2011.
Further highlighting the problem is that the revenue decline has come despite two revenue-boosting trends. First, IBM spent nearly $17 billion on acquisitions over this period. And, “Strategic Imperative Revenues” – those from the advanced technologies – have grown at a compounded rate of 15% over the past six years. These revenues comprise almost 50% of IBM’s total sales, handily surpassing its 40% goal.
One unfortunate problem is that rising demand for Strategic Imperative product lines may be draining away demand for IBM’s legacy products. The migration to cloud computing saves clients considerable cost and hassle, but this means less sales of hardware, software and services. Creative destruction may be the right strategy for long-term survival but it can create real problems for companies like IBM hoping to maintain their revenues in the face of rapid industry changes.
Without revenue growth, what’s left to entice investors?
If the growth story isn’t being propelled by revenues, IBM needs other sources of growth to entice investors. Unfortunately, IBM can’t escape its sluggish top line.
In 2017, IBM’s non-GAAP gross profits3 of $37.5 billion were 25% lower than in 2011. Lower revenues drove the decline. The anemic margin improvement of 0.2 percentage points provides little encouragement that the company’s business mix is helping its growth.
One source of clear improvement is operating costs. Since 2011, the company’s selling, administrative, research and development expenses have declined by 17%, or $4.9 billion. But even this hasn’t been enough to improve IBM’s pre-tax profits, which have fallen nearly 36% since 2011. As a percent of sales, the pre-tax profit margin dipped to 17.5% from 20.2%.
Some relief has come from IBM’s highly talented tax department and a tax cut from Congress. The company’s provision for income taxes (excluding charges related to the enactment of the U.S. tax reform) fell by 82% in the past six years, to $931 million from almost $5.3 billion in 2011. With a lower tax bill, after-tax profits have slid only 21% over this period.
The mitigating effect of its plummeting tax rate, collapsing to a paltry 6.7% from 24.5% in 2011, appear exhausted. IBM is approaching the lower limits of its tax savings.
The real driver of value at IBM
Despite the sharply lower revenues and profits, IBM’s per-share earnings have actually increased since 2011, reaching $13.80, up 3% from $13.44 in 2011. The force behind this impressive feat: the 23% shrinkage in its share count. Even including the dilutive effect of IBM’s stock awards, its current 937 million share count is 277 million smaller than in 2011. Without the share repurchases, IBM’s earnings in 2017 would have been $10.65 per share.
Powering this share count reduction: the company’s prodigious free cash flow4 totaling $84 billion over the last six years. Even after steadily rising dividend payments totaling about $28 billion since 2011, IBM had $56 billion left over for strategic purposes, of which $52 billion went toward repurchasing its shares.
Yet even this driver has lost much of its steam. The strong free cash flow of $16.6 billion in 2011 tapered to $13 billion last year. IBM’s historical commitment to raising its dividend is squeezing what’s left: free cash flow after dividend payments in 2017 of $7.5 billion is little more than half the $13.1 billion in 2011.
IBM may not have a cash crunch like another long-time Dow Jones Industrial Average company (General Electric), but its surplus cash flow is clearly headed in the wrong direction. This heightens investors’ doubts about its ability to continue to acquire companies and repurchase its shares. Could the company, for example, have purchased cloud computing innovator GitHub for $7.5 billion like Microsoft just announced? IBM’s capacity for this type of deal pales in comparison to Microsoft’s, which has $132 billion in cash on hand and generates over $30 billion a year in operating free cash flow. Yet to remain relevant in cloud and other leading edge technologies, this is what IBM must do.
Can IBM borrow its way to shareholder prosperity?
IBM’s balance sheet remains strong. Corporate debt, which excludes debt related to its Global Financing business, is only about $15 billion. This debt is less than the $17.4 billion in estimated 2018 corporate EBITDA, indicating a conservative amount of leverage. Further bolstering its financial position is $10 billion in corporate cash. Global Financing debt is a reasonable 9x its Global Financing equity.
However, while free cash flow after dividends has shrunk, corporate debt has nearly doubled. Comparing one to the other, corporate debt is now twice free cash flow after dividends, whereas it was only about 0.6x in 2011. Credit rating agencies are noticing, as Standard & Poor’s reduced its rating one notch to A+ last year.
IBM’s balance sheet isn’t in jeopardy, and the company likely has plenty of borrowing capacity available, but the trends are affecting management’s decisions. Share repurchases that averaged just over $13 billion a year from 2012-2014 have dwindled to an average of just over $4 billion a year from 2015-2017.
IBM won’t be able to borrow its way to shareholder prosperity forever.
What to do with IBM shares?
While many investors will avoid IBM shares as long as the growth narrative is broken, at what point do they become attractive to value investors focused on cash flows? We think the shares are not cheap enough just yet.
The technology operations (everything other than Global Financing) are currently trading at about 7.8x EV/EBITDA5. For a diversified global technology company that is struggling to produce any growth, but one that has strong technology capabilities and decent cash flow, it is unlikely to garner much higher of a multiple.
We would value the Global Financing operations at about $13/share. The business generates high returns on capital (often above 30%) yet has not grown its book value or profits over the past six years. Given this, it is likely worth about 10x earnings of roughly $1.2 billion, or $12 billion.
Catalyst needed to become interesting as a turnaround investment
To become interesting as a turnaround investment, the company needs a significant catalyst. This could include a change in the leadership, a new stake acquired by a legitimate and capable activist investor, a major restructuring that would include large divestitures, or other changes indicating that it won’t be “business as usual” at IBM. A financial catalyst, such as heavy borrowing to repurchase shares, would likely not produce a long-term improvement in IBM’s underlying fundamentals, rather it would increase the company’s financial stress and further impede its longer-term prospects.
For now, IBM’s board of directors, with its 12 independent members drawn primarily from former heads of iconic American companies, appears to support Rometty. Yet even this notable group is vulnerable to concerns about its governance given the company’s strategic and financial issues.
Without a catalyst, we would look for a valuation that is cheap enough to set aside the stagnant fundamentals. If valuation fell to the 6.5x EV/EBITDA range, the stock would trade for about $115-$120/share. Assuming the $6.28/share annual dividend is sustainable, this price would provide an appealing 5.2% yield, helping investors wait for a catalyst or for simple value accretion over time to make the investment worthwhile.
If the valuation never gets this attractive, investors might be better off bypassing IBM shares. Its fundamental outlook and investor enthusiasm have had too many false starts to allow much conviction that “this time it’s different”.
As Warren Buffett has long stated, "the stock market is a no-called-strike game. You don't have to swing at everything - you can wait for your pitch”.
For us, IBM is not worth a swing just yet. It needs either much lower valuation or a solid catalyst.