The response to the International Business Machines (NYSE:IBM) Investor Day presentation has been muted: nothing was said that moved the needle. Shortly thereafter, CFO Martin Schroeter did another presentation at the Morgan Stanley Technology, Media and Telecom Conference. After reviewing the transcript, I developed the following spreadsheet, which projects the company’s performance out through the year 2018 consistent with management’s planned trajectory.
If the company resumes top line growth and maintains margins, buybacks will drive respectable growth in EPS, with the PE edging upward toward a historical market standard of 15.
The market is currently applying a forward P/E of 9.24, according to Yahoo Finance. A simple reversion to the company’s recent average of 13.5 would provide a fine profit, and respectable returns even if it takes 2 or 3 years to play out.
Progress has been Made
Here’s Schroeter, from the 4Q 2014 earnings conference call:
Our strategic imperatives continue to drive strong growth, up 16% in 2014 and that includes an impact from currency. Together, cloud, analytics, mobile, social and security generated $25 billion in revenue, which is 27% of IBM.
Analytics was up 7% on a large base and with 60% revenue growth, our cloud business is substantial. It’s now $7 billion in revenue and we exited the year with an annual as a service run rate of $3.5 billion. That’s up from $2.2 billion a year ago.
We introduced our cloud platform-as-a-service Bluemix and are shifting capital to globally expand our SoftLayer Cloud Data Centers. We’re bringing Watson’s capabilities to the enterprise and building a partner ecosystem, effectively creating a market for cognitive computing.
We introduced cloud application innovations around Watson Analytics and Verse. We launched POWER8 and are building the OpenPOWER consortium. We formed a partnership with Apple for enterprise mobility with twitter for big data and with SAP and Tencent for cloud. Clearly, we are the go-to platform for the enterprise.
Most of the criticism leveled at the company can be addressed under the heading of capital deployment.
- Buybacks – many market participants believe IBM was guilty of ill-conceived financial engineering. Going forward, buybacks will be 2% to 3% of shares outstanding, or about $5 billion per year, and will not be funded by debt.
- Debt has been maintained at responsible levels, when the analysis includes an allocation between what is necessary to support Global Financial at a 7:1 ratio and all other debt.
- The dividend will be increased: my guess is that it will be consistent with expected EPS growth.
- Acquisitions will continue, and will be targeted toward technology and IP that will enhance the company’s capabilities. IBM has the resources to bring acquired technology to market effectively, creating value.
- R&D – to some extent, IBM is buying technology rather than developing it in-house. Consistent efforts are devoted to directing R&D into the support of strategic imperatives.
- Capex has been directed at data centers in support of the Cloud initiative, and consistently exceeds depreciation.
- Pensions: unfunded pension liabilities have not been decreasing as expected, due to changed assumptions for mortality, discount rate, and return on investments. Since the company expects pension funds to earn 7.5% long term, voluntary contributions would provide acceptable and predictable returns. With the wisdom of hindsight, funds expended on buybacks during the past three years would have been better spent reducing pension underfunding.
“Investing” and Margins
Because IBM’s business doesn’t require a lot of physical capex, investing in growth will frequently take the form of increasing expenses in anticipation of developing future revenue. This will result in lower margins, unless expenses are reduced for existing businesses.
Schroeter acknowledges the problem, and believes that some of the reductions in existing business will be driven by the reallocation of skilled employees to other areas. If the people aren’t in place to bid for a project, they won’t get the business. He also notes that margins will improve when the strategic imperatives ramp and get up to scale.
Also, the increased expenses can’t exceed amounts that will be productive. As an example, $1 billion was earmarked to grow Watson, but has not been fully deployed, presumably because there was nothing the additional funds could do to speed things up.
This all amounts to a 100 cents in the dollar problem. IBM CEO Ginni Rometty undoubtedly is aware of it, since Schroeter talks about it. The company ended 2014 with $6 billion remaining on the buyback authorization, and anticipated spending it. With share prices where they are, that would be an acceptable use of the funds.
A range of 2% to 3% for buybacks leaves considerable room for judgment. Rometty would be well advised to make very, very sure she doesn’t starve viable existing businesses in order to do buybacks or fund strategic imperatives.
Margins and Competition
Two of IBM’s notable competitors have extremely low margin business models: neither Amazon (NASDAQ:AMZN) nor Salesforce.com (NYSE:CRM) make meaningful profits.
Amazon competes on data centers, through AWS (Amazon Web Services). The apparent business plan is to sell at cost and make it up on volume. All I can say is, IBM has been building data centers, and the customers have been coming. Possibly the company has the advantage of being able to make its data centers part of a comprehensive solution to complex business needs, commanding higher margins for the package.
The Salesforce SaaS business model features massive sales and marketing spending, on the order of 2x new revenue. If the sales expenses are disregarded, margins are very high. Logically, customers aren’t getting much service for their subscription fees, since most of it goes to the salesman. So they are either paying too much, or receiving too little.
CRM’s business model will come under considerable pressure as strong competitors such as IBM and Oracle (NYSE:ORCL) come on the scene. If these competitors are effective in using less sales intensive and more performance intensive models, they will achieve better margins overall than Salesforce. Giving all the revenue to the salesman doesn’t make sense for the customer.
This is beginning to be an issue. When asked if she had learned anything from the 2014 debacle, Rometty replied that she had underestimated the pace of technological change, and missed the trend for consumer tech to move into the workplace, the BYOD idea.
Corrective action on these issues is underway. Resources are being shifted toward the strategic imperatives at a more rapid pace. The deal with Apple (NASDAQ:AAPL) demonstrates a focus on becoming relevant at the interface of personal tech and enterprise IT. Additionally, social and mobile are included in the strategic imperatives.
The existing business model is based on high margins and returning capital to shareholders. In practice, it has meant divesting low margin businesses, some of which may have been viable and relevant. It’s difficult to reconcile these priorities with entrepreneurial thinking, where management invests by running higher expenses in order to generate future increased revenues from new business opportunities. While there is no reason to advocate a no-margin business model similar to those used by Salesforce and Amazon, IBM management should be able to integrate entrepreneurial thinking sufficient to drive the transition.
The IBM board is composed primarily of CEOs and former CEOs of major corporations. All of these people are successful and they are familiar with the capital allocation process as a key management responsibility. They gave Rometty a much maligned raise, which I interpret to mean that they believe she is doing a capable job.
Management seems defensive on the capital allocation issue, defending buybacks by talking about long time periods during which shares were bought for substantially less than the current price. But the past three years don’t look fully thought out, in retrospect. Many companies publish a capital allocation priority list: perhaps IBM should look at the issue and do the same.
Why Wait Two Years?
I have a large position in IBM, with meaningful unrealized losses. I’m planning to give it two years to turn around. I use that time frame as my basic starting point, because Graham recommended it in value situations. It’s not too difficult to envision a scenario where the stock will make its way up into the $200 area.
IBM’s business is strongest in the 4th quarter, so making decisions based on periods of less than a year may not be optimal.
I plan to monitor quarterly results to see if revenue and EPS are on a trajectory consistent with that presented earlier in the article. While I think it’s more likely than not that the transition will result in a more relevant company growing both top and bottom lines, there are some reservations about management’s philosophy of capital allocation and indeed about the soundness of the business model, which may place excessive focus on returning capital to shareholders.