IBM's Current Transition Comparable to Apple in 2013
Even though IBM (IBM) has struggled generating revenue growth over the past five years, Big Blue is following a similar path to Apple (AAPL) back in late 2012-2013. Market sentiment for Apple stock was at lows after pundits claimed the iPhone maker had lost its innovative touch. IBM is receiving similar critiques now as the company is transitioning towards high margined software products and services. Share prices of both tech giants were/are down over 40% from market highs. Looking back, Apple was innovating behind the scenes in late 2012 and 2013 to release the cash cows that became the iPhone 5/6. IBM's current transition towards Cloud computing and big data analytics could be seen as a similar situation that will yield future income.
Underperformance
IBM reported Q4 2014 revenues of $24.1 billion, down 12% year over year, which is IBM's 11th straight quarter without a year-over-year revenue increase. Due to the lack of top line growth, IBM shares are down almost 25% over the past seven months. Some of this revenue decrease, though, is intentional.
IBM has been selling its underperforming, less profitable units like commodity servers (sold to Lenovo) and semiconductor manufacturing operations (sold to Globalfoundries).
CEO Virginia Rometty has stated that she will not keep her promise of "Roadmap 2015," which involves returning $20 earnings per share profit by 2015. Several reports suggest that Rometty is overseeing a huge reorganization of the company in the next several years.
Transitioning Towards Growth & Away from Low Margins
IBM revenues have grown at a flat -0.8% over the last five years on a compounded annual rate. In recent years, IBM has been transitioning investment into growth areas like Cloud computing, big data and mobile applications. These growth areas now represent 27.2% of total revenue, up from 23.8% in 2010. Delving into the numbers, Cloud revenue was up 60% to $7 billion, Cloud delivered as a service revenues were up 75% to $3 billion, business analytics revenue was up 7% to $17 billion, and mobile revenue was up over 200%.
These numbers suggest that IBM has been innovating behind the scenes as it transitions into higher growth areas. Although it may take a couple of years for the transition to be complete, this will provide longer-term benefits for shareholders. Management has projected that the software business will comprise 35% to 40% of total sales in the next five years.
Gross margins and operating margins have remained relatively stable in the past five years demonstrating Big Blue's brand name durability and competitive advantages. Divesting low-margined businesses have assisted gross margins, which have risen slightly by 3% over five years.
As IBM Struggles, Company Remains Cash Cow
IBM has continued to generate stellar free cash flows as a percentage of sales, albeit declining, due to its ability to carve out several competitive advantages within the technology sector. As a comparison, Apple generated 26% FCF/Sales yield over the past five years. Over the same time period, IBM's metric was 14%. However, it must be noted that IBM's product portfolio is much more diverse, both in breadth and depth, compared to Apple. Approximately 60% of revenues are generated from one product - the iPhone.
Even with a declining top line, IBM has continued to generate healthy free cash flows during its transitional period. This has enabled the company to use the cash flows to make smaller acquisitions and complement its software portfolio.
Profitable and Operationally Efficient Due to Competitive Advantages
IBM has consistently turned over its assets (given a large asset base) that have led to healthy profit margins. Returns on assets and returns on equity have been extremely consistent even though IBM continues to position its portfolio towards higher growth margins. This is evidence of IBM being able to maintain its pricing strategies, expand its global footprint through a diverse set of services, and customers unwilling to shift away from IBM products and services.
High Switching Costs
IBM's hardware business will likely remain steady as companies will find it challenging to move towards other hardware infrastructure systems. Simply put, such a process is expensive and inconvenient. Moreover, the infrastructure management business is sticky as most IT personnel are trained on IBM's systems. This makes it difficult for customers, such as financial institutions and pharmaceutical companies, to switch to competitors. Imagine if a large financial institution were to switch thousands of workers and client data onto a new system. The costs of new infrastructure, the conversion process and the time to train employees would be a large repellant.
Century Old Reputation
IBM has accumulated an excellent brand image and industry leading reputation over a century of stellar service. When it comes to enterprise solutions, IBM is the first company that comes to mind. As a result, IBM's business consists of long term contracts and demand worth over $140 billion of backlog orders.
Divesting underperforming assets while filling software gaps
Upon her arrival, CEO Virginia Rometty, sold non-core and underperforming assets to make room for acquisitions such as CrossIdeas and LightHouse Security Group. IBM's legacy hardware business is yielding flat to negative annual growth and losing upwards of $500 million annually. Moreover, hardware business margins have decreased in recent years as customers make the shift towards cloud computing, software infrastructure and data analytics to solve their business needs. Rometty, meanwhile, is filling gaps in the IBM software portfolio through acquisitions as she understands the benefits of the software portfolio by positioning Big Blue as a continued leader in a dynamic IT environment.
Valuation
Compared to industry P/E valuations, IBM is trading at a significant discount at current share prices, which may indicate an excellent buying opportunity for shareholders. IBM continues to pay a stable dividend yielding 2.8%. Additionally, the company will continue its shareholder friendly ways by repurchasing $50 billion of stock and paying out $20 billion in dividends in 2015.
Looking at a five-year time frame, IBM is significantly undervalued. The financial benefits of their software transition will likely be shown in FY 2016 and beyond, and thus may influence a turnaround in share performance. Apple's outperformance since their own behind-the-scenes innovation is a situational example that IBM is comparable to. Long term investors must approach an IBM investment with a contrarian's point of view at this time when prices are suppressed.
Implications of software shift
Looking ahead, software and cloud computing applications will likely tilt IBM's revenue mix away from hardware offerings. This isn't necessarily bad, considering hardware business will generate flat to low single-digit revenue growth due to the maturity of IBM products. IBM continued to divest over $7 billion in revenues in the fourth quarter of 2014 as they were generating a $500 million loss. This suggests that IBM has a desire to enter 2015 with a more streamlined product portfolio. Moreover, management will continue to divest several low-margined contracts in the hardware business in favor of increasing exposure to software, which is expected to grow at mid- to high-digits.
IBM continues to transition slowly but steadily towards an increasing exposure to Software and emerging economies. Specifically, IBM has opened SoftLayer data centers in Gemany, Japan, Australia and Mexico, and gained access to nine Equinix data centers in Australia, France, Japan, and the United States. By integrating SoftLayer with the Equinix Cloud Exchange, IBM can expand its reach and attract customers seeking hybrid cloud solutions.
Management guidance suggests that the software business will comprise 35% to 40% of total sales (up from 27% currently) in the next five years. This, in turn, will increase IBM's exposure to higher growth margins and higher cash flows, specifically from emerging markets. Moreover, even during difficult economic conditions, IBM has continued to generate order backlog improvements that will boost revenues in the future. As IT spending rebounds in 2015 and 2016, investors can expect the company to report growth in revenues from emerging economics, which have reported a lackluster performance in the previous quarters.
IBM May Be Down, But Definitely Not Out
Unlike Apple's turnaround (above), IBM's business may take several years to fully recover from its current transition period. Due to IBM's sheer size, it will take time to reap the rewards of the cloud software shift. IBM's current prices could be an excellent buying opportunity for patient investors with long term horizons. When it's all said and done, IBM's 2015 will parallel Apple's situation in 2013.
This article first appeared on GuruFocus.
