The Uncertain Future Of International Business Machines - International Business Machines Corporation (NYSE:IBM)

I have been fascinated by The International Business Machines (IBM) for more than a decade. I covered my frustrations with the company in this detailed article in September last year. In another article, I expressed my anger about the company’s decision to acquire Red Hat (RHT) for $34 billion. This year, investors have continued to purchase the company’s stock, pushing its stock up by more than 24%. As such, it has outperformed the S&P 500 and the Dow Jones Industrial Average. It has also slightly underperformed the S&P technology select sector index. This is understandable because the index is made up of some of the fastest-growing companies in the world. In this article, I will review the progress the company has made and conclude on whether my bearish thesis has changed.

While IBM has performed well this year, its long-term track record has been minimal. In the past ten years, the stock has gained by 41%, which is much lower than the S&P 50 average gain of 240%. During this time, its old-tech peers like Oracle (ORCL), Microsoft (MSFT), and Cisco (CSCO) have gained by 193%, 508%, and 210% respectively.

The reasons why IBM has underperformed are well known. First, its revenue has declined from a high of $104 billion in 2012 to a low of $79.5 billion in 2018. Investors expect this decline to continue to $77.25 billion this year. Second, IBM has missed on the key technology trends of the past decade. It missed the mobile industry that is now dominated by Apple (AAPL) and Alphabet (GOOG). It missed on the cloud computing trend to the likes of Amazon (AMZN) and Microsoft (MSFT). It missed on the customer relations industry that is now dominated by Salesforce (CRM).

Third, IBM is known for its bureaucracy, which impacts how big decisions are made. Further, the company’s board has been complacent by continuing to retain Ginni Rometty, who is an underperforming CEO for more than 7 years. In my past articles, I have argued that for IBM to succeed, it needs to learn from Microsoft, and install an experienced CEO who will lead the turnaround. Microsoft would not be the company it is today if it was not for Satya Nadella.

Finally, the company’s $15 billion bet on Watson has been a big failure. While the management has always touted Watson to be the next big thing in cognitive, a number of companies that use it have not been pleased. This is more so in the sensitive healthcare sector, where the product has given doctors the wrong diagnosis. While Watson could help companies solve many challenges, the overall use case for the product does not justify the $15 billion price tag and hype.

IBM management understands that its future depends on how it performs in the cloud computing sector and how it improves its efficiency.

In recent years, the company has increased its investments in the cloud sector. In 2013, it acquired Softlayer in a deal that was valued at more than $2 billion and last year, it announced the acquisition of Red Hat for more than $34 billion. In March this year, it changed the way it will be recognizing its income. The cognitive solutions will be merged with the integration software and security services, which were previously in the technology services and cloud platforms segment. The Red Hat revenue will be added to the segment once the deal closes. Using the 2018 annual revenue, the cloud segment would have more than $26 billion. That is $18.41 billion for cognitive solutions, $4.4 billion for integration, and $3.36 billion for Red Hat. As such, the complete cloud segment would have been the second one from Microsoft, which had an annual Intelligent Cloud revenue of more than $32 billion. Amazon cloud revenue in the year was more than $25.7 billion.

In public cloud, IBM’s market share of 3.6% is much smaller than that of Amazon, Microsoft, Google, and Alibaba (BABA) according to data from Canalysis. In the most recent quarter, the company’s growth in the cloud sector continued to slow down, even as the sector continues to expand. According to IBM, only 20% of global companies have transitioned to the cloud, which means that there is a problem in how it is executing the transition. In the past quarter, the company had revenues of $5 billion in the cloud and cognitive software segment, which was a 2% decline from the previous quarter. On this, I see two main issues. First, IBM lacks the modern appeal that companies like Google, Amazon, and Microsoft have. As such, many companies like Etsy (ETSY), Spotify (SPOT), Netflix (NFLX), and New York Times (NYT) have moved to the relatively newer services offered by Google, Amazon, and Microsoft.

Second, I see an issue where IBM will need to offer large discounts to customers in a bid to retain market share. To be fair, all companies competing in the cloud sector will need to offer more discounts. Amazon will do this to maintain its market share. However, IBM is more incentivized to offer more discounts to gain market share and accelerate growth, which is waning.

Third, as I have written before, I still believe that IBM made a mistake by buying Red Hat for $34 billion. In 2018, Red Hat had revenues of more than $3.3 billion and an EBITDA of more than $673 million. However, its annual growth has slid from above 22% in 2018 to just 14%. While the company will help IBM become a leader in the hybrid cloud market, I believe that IBM overpaid for the company and did so out of desperation. Transactions done out of desperation – read HP’s acquisition of Autonomy – never end well. Further, this transaction will cause lasting damage to IBM’s balance sheet. In May, the company sold bonds worth more than $20 billion. On top of the existing debt of $50 billion and Red Hat’s debt of $891 million, the company will have debts worth more than $71 billion. Using the most recent quarterly results, the company would have a run rate EBITDA of about $15 billion. As such, the proforma debt / run rate EBITDA would be about 4.7x, which will be in the junk status. This will not be good for a company whose revenue is declining.

Fourth, the future of IBM will depend on how much it can cut its costs. In recent months, the company has announced that it plans to lay off more than 1,700 employees. Obviously, to the affected staff, this is a difficult decision. However, it has to happen for the company to remain competitive and expand its margins. Still, I believe that the layoffs don’t go further enough. In my previous articles, I have argued on the need for IBM to focus on building a leaner company. Part of that approach would be to exit some of its low-margin consulting business.

IBM stock has underperformed the market in the past decade. At the current valuation of $125 billion, investors are paying a 10x multiple on the expected earnings for this year. This is much cheaper than other companies like Oracle, Microsoft, and Cisco, which have a forward PE ratio of 15, 23, and 16. The same is true with other metrics as shown below.

While IBM is an undervalued company, the question is whether you should invest in it. When looking for undervalued companies, I always look at the catalyst that will propel the company higher. For IBM, I can’t find that catalyst. As mentioned above, its cognitive solutions is faltering, its growth in the cloud sector remains slow, and there is no growth in the company’s traditional Systems and consulting businesses. Further, with the company taking more debt, there is the question of the sustainability of its dividend. Therefore, I see no reason why one would invest in the company at the current levels.

Disclosure: I am/we are short IBM. 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.

Source: Seekingalpha.com

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