International Business Machines (IBM): Someday … Over that Rainbow

Posted on Jan 26 2016 - 2:35pm by Dan

For years, I have stated that new retail investors should tune into companies quarterly conference calls, presented to Shareholders. The benefits are numerous.

It only generally takes one hour or so, every three months.

One can become familiar with the businesses with which one is invested.

One can listen to the board members of various corporations around the planet, as they attempt to manage businesses worth billions of dollars. You’re not listening to some doofus and his thoughts on the economy who has no stake in issues facing the economy. You’re not even listening to my thoughts on the economy. You are listening to board members discuss the very real issues they face as they manage multi-national corporations.

When I listen to the conference call of a company, I take some notes. And therefore … I thought that to help out new folks as they navigate conference calls, I would start posting my notes, as I’ve taken them. We have made this a continual feature here at Sharpe Trade with the stocks that we have mentioned in the free Sharpe Income project.

I’ve been a little ‘behind’ during this earnings season, getting caught up on all of the calls.  But we should do so now.  International Business Machines (IBM) recently reported earnings on January 19th, 2016.  The stocks price has dropped by approximately 5.81 % since they released earnings.  As I have mentioned previously here on Sharpe Trade, this is a stock that I use in the equities section of my own personal income accounts.  I hold no IBM for valuation accounts.  This is purely a piece, a cog, in my Income accounts …

International Business Machines (IBM)
1 Hour Chart

International Business Machines Daily Chart

So what’s ‘the low-down’ for this quarter?

You can find my notes on last quarter’s earnings here, and as follows are a few notes from my desk as I listened to this quarters Conference Call …

International Business Machines (IBM) – From January 19, 2016

  • $4.75(5) Est. / $4.84 in Actual EPS.
  • Delivered Revenue of $22.1 billion, Operating net income of $4.7 billion. Both up from last quarter’s numbers (last quarter was 2.95 Billion in Net Income).
  • Earnings per share (EPS) of $4.84 up 44.91% from last quarter and down -16.7% from $5.81 of a year ago.  The continued transformation will play out over time, and with revenue down 2% year over year, and for the second consecutive year … had modest improvement in our year-to-year revenue performance, excluding the impact of currency and divestitures.
  • Last year, cash flow was a problem.  But now, 13 billion of free cash flow, which is up year-to-year, this is 98% of GAAP net income, in line with expectations that free cash flow realization will be in the 90’s.
  • Comments on the on-going transition, or ‘strategic imperatives’ that they feel are not reflected in the revenue stream: Analytics, Cloud (up to 10 billion in 2015), Mobile, Security, Social now represent 35% of the company total, rather than 22% a year ago.  Analytics has 16% YoY growth, Cloud, is up 57%, Mobile, 250%, Security, 12%, Social, 21%.  They will and have deployed capital for Watson Health, Watson IoT (The Weather Co), Cloud acquisitions, including Cleversafe, Clearleap, Cloud data centers, bluemax expansion.
  • Currency translation hit the company by over 7 billion, with an estimated 300 million of impact in the 4th quarter.  Underlying effective tax rate of 14.7% in the fourth quarter.
  • Geography:  Europe returned to growth, led by continued growth in Germany, France, and the UK. In fact, Germany posted double-digit growth and in December.  In Asia Pacific, Japan continued to post growth, led by services. In the Asia Pacific growth markets, had double-digit growth in India and Australia though China declined. U.S. revenue was down. Strong growth in the U.S. in all hardware platforms – zSystems, Power, and storage, but it was offset by weak services and transactional software performance. The growth markets in total were down 4%, roughly in line with the last two quarters, and from a regional perspective, growth in Latin America and the Middle East and Africa was offset by declines in Asia Pacific
  • Segment:  Total revenue was down 2%, and gross margin declined about a point.  Global Technology Services, or GTS sees backlog growth for the year.  GTS gross margin decline is driven by investments in cloud data centers and the ramp of new contracts, which generally have lower up-front margins  GTS saw 37.7% operating profit margins for the 4th quarter. Global Business Services (GBS) sees 4% decline year over year in revenue.  GBS saw 28.2% in profit margins for the 4th quarter.  Pressure in margin seen from transition attempts.  Software saw 6% decline year over year in revenue, with 88.0% operating profit margin.  Systems hardware saw an improvement of 3% year over year in revenue, with 48.0% operating profit margins for the 4th quarter.  Global Financing was down 6% year over year in revenue, with 39.9% operating gross profit margins.
  • Cash Flow:  In the quarter, generation of $7.1 billion of cash from operations, excluding our financing receivables. Invested $1 billion dollars in CapEx, and thus generated $6.1 billion of free cash flow. For the full year, generation of $17 billion of cash from operations, with a full year of almost $4 billion in CapEx, with a significant amount going to support growing services backlog, and for cloud as IBM builds out cloud data centers. And so  a generation of free cash flow of $13.1 billion, an improvement of almost $700 million year to year. The primary driver of this improvement was lower cash tax payments of about $3 billion.  Cash and tax book rates for 2015 were fairly consistent, and so the year-to-year benefit to cash flow was driven by a much higher cash tax rate in 2014. Also had over a $1 billion of improvement in our sales cycle working capital.  Uses of cash$3 billion on acquisitions this year. Acquired 14 companies, including seven in the fourth quarter. The Weather Company acquisition will close in the first half of 2016. Over the course of the year IBM has returned $9.5 billion to shareholders including dividends of nearly $5 billion and $4.6 billion in gross share repurchases. IBM bought back 30 million shares, reducing average share count by 2.7%. At the end of the year, there is $5.6 billion remaining in our buy back authorization.
  • Balance Sheet:  Ended the quarter with a cash balance of $8.2 billion. Total debt was nearly $40 billion, of which $27 billion was in support of the financing business. The leverage in the financing business remains just over seven to one. The credit quality of our financing receivables remains strong at 55% investment grade. The year-to-year reduction in investment grade was driven by rating changes to existing portfolio, not by changing approach to the market.  Debt-to-cap ratio was impacted again this year by a reduction in equity due to currency translation, and pension re-measurement. Together, these impacted equity by about $3.5 billion.  Funding levels remain solid with the U.S. and worldwide tax-qualified plans at 101% and 97% respectively.
  • Question and Answers:  “Patricia and I will take your questions“.  Interesting.  The second time we have not heard from the CEO on the conference call.  At all, and they seem to be announcing this fact right up front.  
  • Q&A:  A few modeling questions on Software declines, Services, power, etc.   Questions in large part had to do with drop-off in Software (large part of IBM business), and for each question, management sees what is going on with segments … they tend to see their statements in-line with previous guidance and statements, though there may be interim static.  Power in 2015 is starting to grow, which it hasn’t for some time, despite Unix environment.  Currency impact on year to year basis is running about 1.3 billion.  …  Enterprise License Agreements (ELA) a powerful way for clients to  have broad access to the portfolio like the middleware platform, which is quite valuable to them as they think about their hybrid cloud environment. IBM does more ELAs, more Enterprise License Agreements, IBM did more in 2015 and we did in 2014. IBM has not seen a dramatic change in the length of time IBM clients commit to the platform for those.  Renewal rates for the subscription and support that underpins their deployment of those continues at very high rates. Question came up on when we can see when flexible rate strategy on Software will see software growth, which is the most profitable area of the company … The answer was such that they believe the acquisitions will help here, they somewhat bridged the specifics of the question.  There was no specific answer as to when we would see this.  All that was said, was that the renewal rates are staying high on Software and they expect this to continue.  No specifics as to ‘when’.  So the next question brought this out:  We haven’t gotten a specific answer on ‘can IBM grow software in 2016?’, (for those that are new, Software is the largest segment of their business).  The immediate answer was to talk about the very small SaaS.  It was at least admitted in the answer, that SaaS is small, and not going to contribute to the top-line, but that it will drive into other segments of Software.  All well and good.  And timing such improvements can be tricky.  However, again, the question was somewhat ‘bridged’ to be avoided, by talking about strategy in Software.  They do believe their will be profit expansion in 2016; which is apart from the growth.

Briefly put, International Business Machines (IBM) continues a long, and difficult transition, during currency headwinds as emerging markets suffer from the Dollar. If I had to guess (and that’s all it is), the stocks price will continue to see declines, and it’s a bit of a value trap at the moment.  The entire focus at this point, is on growing software.  I still believe the company can make it through the transition, with a higher profit margin business.  The real question, is how big of a company will IBM be at that point?  WHEN is becoming the important question, especially in regards to software.  And how much of a competitive edge are they losing to Amazon (AMZN) and Microsoft (MSFT) while they spend time transitioning?

I would imagine by this point, IBM management is beginning to think of singing “Somewhere Over the Rainbow“, when thinking of completing this transition  …

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