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International Business Machines (IBM) - Thesis

International Business Machine (IBM) – Thesis
Rating: BUY
Current Price: $131.57 per share
Price Target: $205 per share


Thesis:
To say the least, IBM has been beat up over the last several years.  Revenue has declined in 14 consecutive quarters and the stock price has lost a third of its value.  Media pundits decry things like “IBM missed the cloud opportunity,” and “it’s a dinosaur kept alive with financial engineering.”  But the reality is that IBM is a cash generation machine.  It is currently significantly undervalued by the market, and it has a clear path to increasing its intrinsic value even further.

Why has IBM’s stock price declined?  For starters, IBM’s stock price has declined because revenue, profits and guidance are declining.  And IBM looks even worse when compared to some of its hyped-up peers that are receiving all sorts of cloud glorification (e.g. Amazon Web Services, more on this later).  However, IBM’s declining revenues and profits are not entirely due to bad decisions by the company.  In addition to bad decisions (such as their cloud strategy, more on this below) the declines are also due to the same macroeconomic headwinds that other companies are facing, as well as spending by IBM to reposition itself for more profits in the future.  It is worth reviewing some of these factors to help shed light on the partially-false narrative that IBM’s revenues and profits are declining simply because it is a horrible company (IBM is not a horrible company).

IBM’s legacy businesses are shrinking:  IBM’s largest business segment, Global Services (which is a combination of Global Technology Services and Global Business Services) has a shrinking backlog of work.  Approximately 60 percent of the segment’s external revenue is annuity based (annual report, p.29)  coming primarily from outsourcing and maintenance arrangements.  This is a very nice revenue stream for IBM, but it creates a challenge for the company because the backlog is shrinking.  For example, IBM’s backlog was $118 billion at the end of the third quarter (third quarter results) , down from $128.4 billion at the end of 2014 and $142.8 billion at the end of 2013 (annual report, p.35).  To prevent further valuation declines, IBM will need to find a way to replace this shrinking backlog (we’ll talk more about the company’s “strategic imperatives” later).

IBM continues to divest of some businesses altogether:  IBM gave up approximately $7 billion of revenue in 2014 as it divested of businesses that no longer fit its strategic profile (annual report, p.3).  For example, IBM announced the divestment of industry standard servers, customer care business process outsourcing services and its microelectronics business.  These were unprofitable businesses, but they are still a significant part of the reason IBM’s top line revenues continue to decline.

IBM’s nuanced cloud strategy is weak:  IBM is supposed to be a nice safe company, and many investors buy the stock because of this and its attractive dividend.  However, it is this nice safe approach to running the business that caused IBM to essentially miss the boat with regards to the cloud.  Rather than aggressively pursuing industry-wide cloud, IBM chose a nuanced hybrid-cloud approach whereby they fuse new client solutions with their existing systems.  IBM believes they are uniquely qualified to bring value to clients via this hybrid approach, and it also fits nicely with the company’s long-term story of evolving from a hardware company, to a software company, to a services company (annual report, p.28).  However, if IBM senior management was more aggressive they would have recognized they were also uniquely positioned a few years ago to aggressively pursue the cloud because of the company’s huge free cash flows, strong brand name, and long history of hardware, software and services.  Instead, IBM chose the “safe” approach, and more aggressive firms like Amazon (Amazon Web Services) and Microsoft (Azure) stepped in and are now emerging as the dominant players in the space.  Even from a cloud services approach, IBM is getting out hustled by Accenture because of that firm’s agility and willingness to adapt to newer opportunities.  For example, Accenture recently purchased Cloud Sherpas and has also formed a strategic alliance with Amazon Web Services (Amazon Q3 release, p.3).

In IBM’s defense, its shareholders would probably not have tolerated a halt in share buybacks and a halt in divided growth in order to use free cash flows to more aggressively pursue the cloud.  By comparison, Jeff Bezos over at Amazon doesn’t pay a dividend, halted share buybacks, and allowed the company to generate negative net income in order to aggressively pursue growth opportunities such as the cloud via Amazon Web Services.  This behavior simply would not fly among IBM’s shareholders who prefer a nice “safe” company with an attractive dividend yield.

IBM’s growth markets have declined:  Not unlike other companies, IBM’s revenues have declined in emerging markets.  For example, revenue from the BRIC countries (Brazil, Russia, India and China) decreased 10.7% in 2014 (they decreased only 5% adjusted for divestitures and currency, annual report, p.24).  These declines have more to do with global economic conditions than anything IBM did in particular, but they are still detractors, and they help explain why IBM’s overall revenue continues to decline.

Foreign currency continues to negatively impact IBM:  Declining revenues are not appealing, but in the case of IBM it is not entirely because of bad decisions by management.  For example, IBM’s net income fell 13.9% during the most recent third quarter versus the same quarter a year ago.  However, 12.9% of the decline was due to foreign currency impacts.  It’s important to understand the impact of FX because without doing so it’s easy to mistakenly assume all of IBM’s declines are due to poor management decisions.  Currency exchange rates are out of management’s control (and hedging is expensive and imprecise).  Absent FX, IBM’s declines are not as bad as they seem.

IBM is spending now for future growth and profits.  Despite IBM’s sub-par cloud strategy, they are still spending heavily to implement it, and it may contribute to increased profitability in the future.  The risk is that IBM’s cloud strategy may cannibalize its existing business more than it creates new business.  For some color, in 2014 IBM spent approximately 6 percent of its revenue on research and development (R&D) and invested approximately $4 billion on capital investments, largely cloud related.  For example, IBM launched Bluemix, the company’s cloud platform-as-a service for the enterprise.  It also invested to globally expand its SoftLayer cloud datacenters.  Additionally, IBM introduced cloud application innovations around Watson Analytics and Verse (annual report, pp 4-5).  IBM believes spending on R&D will help the company succeed in the future.

What is IBM worth?
A basic discounted cash flow model suggests the market is expecting IBM to shrink about 3.3% per year into the future.  For example, over the 12-month period ended September 30, 2015 the company generated $17.8 billion in cash from operations, and spent $3.7 billion on capex (IBM Q3-15 and Q4-14 reports), yielding a simplified free cash flow of $14.0 billion (for reference, over the last several years IBM has consistently spent between 20% - 25% of its cash flow from operations on capex).  Assuming the firm’s weighted average cost of capital is 7%, we can back into IBM’s current stock price by assigning the company a negative 3.3% annual growth rate.  And while IBM’s absolute free cash flows have actually shrunk about 3.3% per year over the last several years, it seems unlikely that they will continue to shrink at this rate indefinitely into the future considering the unique circumstances over the last several years such as strong foreign currency headwinds, divesting of unprofitable businesses, weak emerging market conditions, and spending on initiatives that are expected to yield future growth.  Even if IBM were to simply sustain its current business (0% growth) our discounted cash flow model suggest the stock is worth around $205 per share, roughly 45% higher than its current price.  And if the company were to grow at all then it would be worth even more.

Another approach to valuing IBM is to compare it to Accenture, which is essentially its closest competitor in terms of the types of business and technology services revenues the two companies generate.  The following table compares Accenture to IBM’s Global Services segment (the company’s largest segment by revenue and pre-tax income at around 60% and 48%, respectively).

Source: Google Finance and IBM Q3-15 and Q4-14 reports

And while IBM’s Global Services revenues are more than 50% higher than Accenture’s, the margins are very similar (although IBM’s are slightly better).  And considering Accenture trades at roughly 16.1 times its pre-tax income (which seems reasonable), IBM’s Global Services segment should command a stock price of around $146 per share.  And $146 per share is slightly higher than IBM’s actual stock price, and it completely excludes the value of IBM’s other business segments: Software, Systems and Technology, and Global Finance.  Granted this is not exactly an apples-to-apples comparison (for example Accenture has been experiencing higher growth than IBM), but it still suggests IBM may not be receiving a high enough valuation from market.

IBM and Financial Engineering
Other companies (e.g. Amazon, Microsoft, Accenture) are suffering the same headwinds as IBM (e.g. foreign currency challenges and weak emerging markets) but they’ve more than offset them with growth.  By comparison, IBM has not grown and has attempted to satisfy shareholders with dividends and share buybacks.  A common complaint against IBM is that these uses of cash are just financial engineering techniques used to boost earnings per share (and to some extent its stock price).  We tend to believe these things are more an indication of good stewardship by management, but they are certainly no substitute for good old fashioned organic growth.

But again, in IBM’s defense, investors are attracted to the company’s low-beta stability.  Part of the reason IBM is able to consistently return so much cash to shareholders (dividends and share buybacks) is because of its steady backlog of business.  And as IBM continues to pale in comparison to its glamorized cloud competitors, its stock price has fallen, and its dividend yield has increased to historically high levels.  This should attract more “safe-dividend” type investors to IBM because the dividend is not in jeopardy of being cut based on IBM’s large free cash flow generation.

How can IBM reverse its decline?
If IBM only maintains its current level of business (i.e. it neither shrinks nor grows) then it is still worth significantly more than its current stock price suggests (as noted in our valuation analysis above).  We believe the declines in revenue and profits will likely cease for a variety of reasons.  For example, the rate of IBM’s significant divestment activities will slow as the company finishes purging its unprofitable and non-strategic businesses.  As this happens, revenue declines will cease, and the profitability of the remaining revenue will be higher.  Next, the significant declines IBM has experienced due to foreign currency headwinds will likely stabilize, and perhaps even work in IBM’s favor in the future.  Further, the declines in emerging markets will likely slow and perhaps even reverse as those economies stabilize.  In fact, IBM will likely experience future growth as the overall economy grows.  Also, IBM has a variety of “strategic imperatives” that will replace declines in legacy businesses and perhaps even add significantly to future growth.

IBM’s strategic imperatives include data, cloud and engagement (annual report, p.26).  IBM believes these imperatives are transforming the IT industry, and that they are uniquely positioned help clients and to profit.  Specifically, IBM believes data is the world’s new “natural resource,” and their unique capabilities (such as Watson) will enable them to help clients by refining it.  Regarding the cloud, IBM believes they are poised to help enterprises reinvent their entire business models with their cloud computing strategies (again, note IBM’s strategy is about helping large enterprises with hybrid-cloud rather than pursuing newer opportunities with newer companies).  And with regards to engagement, including mobile and social technologies, IBM believes they will be a part of fundamentally changing how people interact and get work done (said differently, IBM has vast relationships with existing clients that will ask for help in these areas).  Certainly these strategic imperatives provide growth opportunities for IBM, but the extent to which the company succeeds in implementing them will determine if IBM is able to grow enough to offset their declining legacy businesses and perhaps even grow overall.

Conclusion:
IBM is enormously profitable.  Its revenues are enormous, its margins are high, its cost of capital is low, its cash flows are steady, its future prospects are looking up, its dividend yield is attractive, and the stock is currently on sale.  And while IBM’s cloud business pales in comparison to some of the high-flying glamorized cloud solutions offered by companies like Amazon Web Services and Accenture’s “Cloud Sherpa,” that’s totally fine.  IBM’s shareholders don’t want these high-risk high-volatility opportunities.  They want IBM.

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