Summary
- IBM's earnings release last week was well received and the shares have further appreciated after a strong YTD performance.
- IBM once again missed its revenue targets.
- IBM has provided a minimum of guidance with the expectation of fleshing out expectations on 8/2 when it discusses its post Red Hat future.
- A careful inspection of the income statement suggests worrisome trends that have probably not been carefully evaluated.
- The company's market share losses show no signs of abating, making the current valuation no investment bargain.
IBM’s Margin Pivot; It doesn’t even achieve the smoke and mirrors status
IBM’s second quarter results were essentially a buffet of mediocrity. There are those writers on this site who seem to have felt encouraged by the results-and it is true that once again, IBM reported an upside compared to EPS projections. But once again, IBM missed revenue expectations, and the company continued its saga of shrinking-and at a faster rate than in Q1. At the time of writing this, IBM shares have reacted positively to the reported results, increasing by 4% since release of the numbers, compared to a fall of a couple of percent by the market in general. And the shares have appreciated by 32%year-to-date, compared to the 14% appreciation of the IGV and the 6% appreciation of the S&P 500. Much of this out performance is apparently catch-up for IBM’s earlier share price under-performance; the shares have only appreciated 3% in the last 12 months.
So, what now for IBM shares. I doubt that IBM’s results have changed anyone’s opinions on the company’s prospects or their opinion of the shares. Earnings guidance, despite the beat in the quarter, was reaffirmed-and that is really because under the covers, the source of the earnings beat was essentially non-recurring and had nothing to do with operating performance.
Management is not providing any kind of specific forecasts that include Red Hat for the balance of the year until August 2nd. The CFO said that the company wanted to provide a picture of core IBM, before the impact of the Red Hat merger. Almost certainly, the initial guide will show some level of dilution because of the deferred revenue write down. Thus, even the August 2nd event is likely to leave lots of unanswered questions.
Again, I think it fair to point out that IBM’s results have come in the midst of a huge boom in the IT space. That boom, while showing no signs of really ending, is showing some signs of slowing. One is left to wonder how a company that is demonstrably losing share might fare if there really were a downturn in the IT firmament.
I write about investments, and at the end of the day, IBM is supposed to be a total return investment. As such, it needs to demonstrate some reason why it should be part of a portfolio with other large tech names that are slow growing and which pay a dividend. IBM’s dividend is substantial and it is for this reason that many investors have stuck with the shares. I get that, and particularly for individual investors who have tax consequences to consider, it becomes hard to break from an investment of this kind.
But since it is shrinking in terms of revenues, to a certain extent, the returns being received by shareholders are return of capital and don’t really relate to the economic position of the business. Last quarter did see a noticeable improvement in gross margins which rose 100 bps year on year. But while the overall gross margin percentage rose, it should be noted that gross margin dollars fell-a function of the poor performance of the company’s cloud and software businesses. In addition, operating expenses rose somewhat; IBM’s operating income percentage fell to 12.3% compared to 16.2% in the prior year. As has happened many times in the past, IBM’s “beat” was because of a substantial swing in other income which wound up contributing about 20% of pre-tax income and a slightly lower tax rate accrual than had been forecast. Most other companies would probably be rated as having missed on revenues and missed on margins as well, which is not the set of ingredients I would want to see in an equity that I owned.
