IBM (IBM, Financial) reported its fourth-quarter earnings last week. According to CNBC, IBM beat expectations on both top and bottom lines, but revenue still fell for the 19th straight quarter.
The $162 billion tech company delivered a 2.2% drop in sales, down to $79.9 billion, and a 10% drop in profits, down to $11.9 billion.
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"In 2016, our strategic imperatives grew to represent more than 40% of our total revenue, and we have established ourselves as the industry's leading cognitive solutions and cloud platform company.
"IBM Watson is the world's leading AI platform for business, and emerging solutions such as IBM Blockchain are enabling new levels of trust in transactions of every kind. More and more clients are choosing the IBM Cloud because of its differentiated capabilities, which are helping to transform industries, such as financial services, airlines, and retail."Â –Â Ginni Rometty, IBM chairman, president and CEO
Despite the poor performance, shares of the tech giant jumped by 2.21% that day after the announcement while the broader Standard & Poor's 500 index closed relatively flat at 0.34% change.
Outlook
According to IBM’s Earnings Press Release, the tech giant expects at least a GAAP diluted earnings per share (EPS) of $11.95, a 3.6% drop from fiscal 2016’s EPS.
Market performance
According to Morningstar data, IBM had one- and five-year total returns of 44.5% and 0.4% compared with the S&P 500 index’s 24.9% and 13.96%.
Valuations
According to GuruFocus data, IBM had a trailing price-earnings (P/E) ratio of 13.8 times (industry median of 24.9), price-book (P/B) ratio of 9.5 times (industry median of 2.9) and price-sales (P/S) ratio of 2 times (industry median of 2.3). The company also had a trailing dividend yield of 3.23% with a 44% payout ratio and a 3.1% share buyback ratio.
IBM
In its filing, IBM was founded 105 years ago in New York as the Computing-Tabulating-Recording Co., which was a consolidation of the Computing Scale Co. of America, the Tabulating Machine Co. and The International Time Recording Co. of New York.
In current times, the company creates value for clients through integrated solutions and products that leverage data, information technology, deep expertise in industries and business processes and a broad ecosystem of partners and alliances.
In fiscal 2015, IBM generated 47%, or $38.5 billion, of its sales (excluding OEM revenue) from the Americas followed by 32% from Europe/Middle East/Africa and 21% from the Asia Pacific.
IBM has five business segments: Global Services, Software, Systems Hardware and Global Financing. The Global Services segment itself can be further divided into two segments: Global Technology Services and Global Business Services.
(10-K and Earnings Press Release, IBM)
Global Services
IBM’s Global Services segment is a critical component of the company's strategy of providing IT infrastructure and business insight and solutions to clients. These solutions include IBM software and systems as well as other suppliers' products upon requirement.
According to IBM, approximately 60% of external Global Services segment revenue is annuity based, coming primarily from outsourcing and maintenance arrangements. In addition, the Global Services backlog provides a solid revenue base entering each year.
Global Services has both the Global Technology Services and Global Business Services segments.
Global Technology Services
Global Technology Services provide IT infrastructure services, creating business value for clients through integrated services, incorporating unique intellectual property within its global delivery model.
The segment has several capabilities including strategic outsourcing, integrated technology services, cloud services and technology support or maintenance services.
In fiscal 2015, Global Technology services slumped and delivered a 9.7% drop in sales and contributed 37% – largest among IBM segments –Â to total IBM sales. The segment had $32.84 billion sales in 2015 compared to $36.4 billion in 2014. Global Technology also had a pretax profit margin of 15%.
Cloud Solutions
In fiscal 2016, IBM reported a recast in its segments. Instead of Global Technology services, IBM identified Cloud Solutions as a segment and also modified Global Technology services with Cloud Platforms.
According to its 10-K filing, IBM described itself as more than a hardware, software and services company transforming into a cognitive solutions and cloud platform company.
The Cloud Solutions segment can be briefly described as cognitive, advanced analytics and key data are being integrated into all leading solutions, as per IBM.
In 2016, IBM reported that its Cloud Solutions segment showed a 3.8% growth year on year. Cloud Solutions delivered 24% to total IBM sales, excluding adjusted and as found on its unaudited press release in the recent period.
The segment generated $20.8 billion in revenue compared to $20 billion in 2014 and delivered a pretax profit margin of 31% compared to 36% the year prior.
Technology Services and Cloud Platform
Similar to Cloud Solutions, the Technology Services and Cloud Platform segment was identified in the recent earnings press release.
IBM’s Cloud Platform introduces new solutions that will be built on the IBM Cloud. Cloud Platform is the heart of IBM’s digital transformation. The platform makes applications work across on-premise, public and private cloud environments.
According to IBM, the platform includes IBM Cloud's Infrastructure-as-a-Service; Bluemix (IBM's Platform-as-a-Service); IBM Cloud Marketplace and the following acquired companies: Blue Box Group (private cloud), Compose (database-as-a-service), StrongLoop (developer technology), Cleversafe (object-based storage), Gravitant (cloud brokerage) and Clearleap (cloud-based video) and The Weather Company among other IBM strategic partnerships.
In fiscal 2016, Technology Services and Cloud Platform grew 0.6% to $36 billion from $35.84 billion the year prior. The segment is the largest revenue generator for IBM comprising 42% of total IBM sales for fiscal 2016, excluding adjustments. The segment delivered a pretax margin of 13%.
Global Business Services
This segment offers professional services that deliver business value and innovation to clients through solutions that leverage industry and business process expertise. The segment's role is to integrate IBM content and solutions with its client’s strategic imperatives.
Similar to Global Technology, this segment also has several capabilities including Consulting and Systems Integration, Application Management Services and Global Process Services.
In fiscal 2015, Global Business Services also slumped in sales with a negative 12% change, down to $17.7 billion in sales from $20 billion the year prior. The segment contributed 20% in total IBM sales and generated a pretax margin of 14.9%.
In fiscal 2016, Global Business services still fail to grow with a negative 3.1% change in overall sales and delivered a pretax margin of 10% compared to 15% the year prior.
Software
IBM’s software segment consists primarily of middleware and operating systems software.
Middleware serves as a software layer that connects operating systems to applications across a standard software platform (1). Meanwhile, operating systems are the software engines that run computers.
According to IBM, about 70% of external Software segment revenue is annuity based, coming from recurring license charges, software sold "as-a-Service" and ongoing post-contract support. The remaining revenue relates to one-time charge arrangements in which clients pay one upfront payment for a perpetual license.
IBM’s software segment also has several capabilities including WebSphere, Information Management, Tivoli, Workforce Solutions and Rational. The segment also has IBM’s Watson, Watson Health and Watson Internet of Things.
IBM described Watson as the first commercially available cognitive computing platform that has the ability to interact in natural language, processing vast amounts of big data and learning from its interactions with people and computers.
In fiscal 2015, IBM’s Software segment also suffered negative overall sales growth down 9.4% to $26.2 billion from $28.9 billion the prior year while representing a 29% in total revenue contribution and carrying a pretax profit margin of 34.6%.
In fiscal 2016, financial figures for the Software segment would have been integrated to either the Cognitive Solutions segment or the Technology Services & Cloud Platforms segment.
Systems Hardware
IBM’s Systems Hardware provides clients with innovative infrastructure technologies to help meet the corresponding new requirements of hybrid cloud and cognitive workloads.
Systems hardware also has several capabilities such as servers, storage and technology.
In fiscal 2015, Systems Hardware suffered similar negative sales growth figures, dropping 24.5%. Sales were down to $8 billion from $10.6 billion in 2014. The segment generated 9% of total IBM sales for the period while having delivered a pretax profit margin of 7.5%.
In fiscal 2016, IBM included its operating systems figures from its software segment in the Systems Hardware segment and identified it as solely the Systems segment.
The modified segment still failed to generate positive growth in sales and delivered a negative 18% overall sales growth and also had a pretax margin of 11% compared to 17% the year prior.
Global Financing
IBM’s Global Financing facilitates IBM clients' acquisition of information technology systems, software and services by providing financing solutions in the areas where the company has the expertise.
The segment also has several capabilities such as client and commercial financing and remanufacturing and remarketing. Remanufacturing and remarketing, in particular, involves selling or leasing of used equipment returned from lease transactions, or used surplus equipment acquired internally or externally.
In 2015, Global Financing had a negative 1% change in its sales year on year, down to $4.5 billion while having a pretax margin of 52.8% and representing 5% of total IBM sales.
In 2016, Global Financing sales were further reduced by 22%. The segment delivered a pretax profit margin of 47%.
Overall, IBM had five-year sales and profit growth and operating margin averages of -3.9%, -2.3% and 20% (2).
Cash, debt and book value
As of December, IBM had $8.53 billion in cash and marketable securities and $42.2 billion in debt with a debt-equity ratio of 2.3 times compared to 2.8 times the prior year. IBM also had 34.8% of its $117.5 billion total assets in goodwill and intangibles while having a book value of $18.4 billion compared to $14.4 billion in 2015.
Cash flow
(Earnings Press Release, IBM)
For its 2016 operations, IBM had a -2.9% change in its cash flow from operations, down to $16.5 billion from $17 billion. The main difference was IBM had lesser profits and increase cash outlay in its working capital.
Capital expenditures for the tech giant were $3.73 billion leaving it with $12.8 billion in free cash flow, compared to $13.2 billion the prior year.
(10-K and Earnings Press Release, IBM)
IBM also allocated 68.5%, or $8.8 billion, of its free cash flow in dividends and share buybacks. On average, IBM allocated 117% of its free cash flow in dividends and buybacks in the past three fiscal years. As observed, cash flow payouts have been more controlled, in a good way, in recent years.
IBM also took in $2.8 billion debt, net of payments and proceeds, in 2016.
Conclusion
IBM, despite its old age, is a giant cash flow machine. Free cash flow, in particular, is still somewhat supportive of IBM's tremendous shareholder payouts despite its struggling business segments.
In review, the tech giant handed out a total of $54 billion in dividends and share buybacks from a total free cash flow of $52 billion from fiscal 2013 to 2016.
Its poor business growth performance and leveraged balance sheet, though, should turn off some prospecting investors. Post-earnings announcement, IBM shares were much appreciated despite terrible underperformance in recent years.
Using its projected diluted EPS for fiscal 2017 and multiplying it with the past five-year earnings multiple averages and applying a 20% margin gave a value of $120 a share, or 10 times fiscal 2017 earnings.
The analysts at Stifel think otherwise and instead rated IBM shares a buy while raising its target price to $192 from $165, or 16 times IBM’s forecasted 2017 EPS.
(IBM shares at $170.55 with trailing P/E ratio of 13.8 times, GuruFocus)
In summary, IBM shares are a sell with a target price of about $140.
Notes
(1) 10-K: The IBM Middleware portfolio allows seamless integration of unrelated systems, processes, and applications all while providing market leading functionality, in both on-premise and hybrid cloud environments.
(2) Morningstar data.
Disclosure: I have shares in IBM but already initiated to sell at market open.
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