- The services giant reports GAAP EPS down 8% after $12B of buybacks this year.
- $44B in debt leaves shareholders with nothing but an equity stake in intangibles and goodwill.
- Factoring in 10% growth going forward, the business still hasn't hit our consider buy price.
- Cloud revenues up to annual run-rate of $3.1B
- Mobile revenues more than doubled
- Security revenues up more than 20% year-to-date
- Server and micro electronics businesses jettisoned
These are important points, however, they make up such a small piece of the $100B pie that they would need to grow at the same rate for another 2 years, just to make up for the revenue shortfall this year. Couple that with the fact that the bulk of the growth above results in loss-making for the foreseeable future and the 'highlights'rapidly become 'vaguely interesting'.
Reading the prepared remarks does help shed some light on where the business is going to be shifting to and how that helps drive growth in the future, but it's all a bit 'thin on the ground'.
The growth strategy as articulated by Martin Schroeter was:
- Remix to higher value by offloading fabrication to GLOBALFOUNDRIES. This will free up capital, remove profit-drag and allow IBM to access the same supply mechanism at market-based pricing for the long-term.
- Dedicated business units for cloud, security and smarter commerce, enabling more focused investment and quicker turnaround in bringing solutions to the market.
- Simplified structure and increased productivity.
While I understand all three, this doesn't feel like innovation to me.This is very much a back-to-basics approach and that is concerning for a business that seemed to be driving a 'smarter, connected everything' message to the market while seemingly not delivering that for itself internally.
The standout piece of this growth strategy is in point 2 above. Focusing in on key strategic imperatives, particularly security and commerce, which will only become more important in the 'internet of things' world that we are rushing towards.
Cost structure and margins
As investors, we all need to understand this business is in major flux and has been for the better part of 10 years. The shift to very intellectualised services with the slow but steady disintegration of fabrication has seen this business evolve rapidly over the past decade. The most recent divestiture will result in at least a 4% / $4B drop in annual revenues and this will have a positive impact on margin overall. This is all easy to wrap our heads around. The problem for me comes in the 'expense to revenue' line and the 'pre-tax margin' after the loss-making units have been removed.
Seeing an expense to revenue figure that is moving up after these units have been jettisoned makes me very nervous. Perhaps the management team hasn't responded quickly enough and there is still additional cost-structure to be removed, however, I am always of the view that these deals are reported on quite accurately, so most associated cost has been rolled-up into discontinued operations and this handy line probably hides one or two sins at the same time. Bottom line is, I would expect to see the positive effect baked into a report like this - and it isn't.
Debt-laden buyback approach is not good for shareholders
I have no problem with buybacks - I think they are a legitimate way to return shareholder value - if the business funds it and not the banks. IBM has taken on $44B of debt overall and $6B in the last nine months and has slowly sold off most of the tangible assets. What we're left with is a picture of poor health indeed. Intangibles and goodwill stand at ~$35B while shareholders' equity has plunged to $14.4B. Basically, shareholders have taken an $8B / 37% smack to their equity while the business has bought back roughly 10% of the shares. This points to a poorly executed, debt-laden buyback model that is robbing shareholders of value, not creating it.
The company looks fair when you review it's ratings, however, there are some warning signs overall. Firstly our engine shows that Strength is dropping, but the business is still strong. Returns, having dipped, are rising again - this is hardly surprising given the fact that shareholder equity is being leaked, so return numbers are artificially higher. Again, the business has no Intrinsic Value rating and this is basically all intangible. Dividends are funded out of free cash, they are affordable, steady and growing. Earnings Predictability scores are starting to look erratic and this is a tell-tale warning sign.
High investment levels should reap high returns
Based on the investment level, we would have expected to see 9% of growth, instead of pretty much the opposite. This highlights how the business is not performing at anything close to optimum and nothing like its track record.
The business is approaching our consider buy price but we'll need the Q3 results to filter through before we make any judgment calls.This might be heading into value play territory, but we are concerned with the signs we see and our Intrinsic Value rating wouldn't allow us to open a position, even if it dips below our $157 entry target.
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