IBM trades at a forward earnings multiple of 9x and has a dividend yield approaching 4%. The stock is either really cheap, or the market is sniffing out more trouble ahead with management’s current strategy. We aren’t ready to jump in just yet and keep the stock out of our Top 20 Dividend Stocks portfolio for now.
However, Warren Buffett sees value and added to his position during the third quarter as IBM reported another disappointing set of results. IBM’s third quarter revenue declined for the 14th straight quarter and came in below all 17 analysts’ estimates.
While there is plenty of talk about how the move to off-premise cloud computing is hurting many of IBM’s “old technology” businesses today, IBM’s current struggles have been developing for years. The company’s sales fell 5% in 2013, 7% in 2014, and are expected to drop over 10% in 2015, including divestitures. A smaller decline is expected in 2016, but it remains to be seen if management can finally stop the bleeding.
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Despite stagnant revenue (sales were $91.1 billion in 2005 compared to $$92.8 billion in 2014), IBM’s management team has obsessed over meeting expectations for earnings growth, trading off long term business prosperity for near term earnings “beats.”
The company has repurchased about 40% of its shares since 2005 and implemented numerous cost reduction efforts, including substantial layoffs in recent years, to grow earnings. For a while, these actions looked to be working. Diluted earnings per share nearly tripled from 2005 through 2013 and operating margins doubled to hit 20%. Even IBM’s stock was a winner, significantly outpacing the S&P 500 from 2005 through 2011.
However, IBM’s cutting finally caught up with it in several ways. In the technology sector, innovation is everything. Innovation thrives in a culture that rewards experimentation and new ideas, not layoffs and strict adherence to quarterly EPS targets.
Gauging innovation and company culture is difficult, but a website called Glassdoor.com aggregates employee reviews for thousands of companies. As seen below, IBM ranks last in overall stars, the percentage of employees who would recommend the company to a friend, and the percentage of employees who approve of the CEO.
This speaks to the internal turmoil that chronic layoffs and cost cutting have had on IBM’s culture. If you were an up-and-coming software engineer, why would you want to work for IBM? The company lacks the vision and inspiration of an Amazon or a Google.
Culture is one thing. Financial decisions are another. As we mentioned, IBM decided to repurchase about 40% of its shares over the last decade, spending over $100 billion to get the job done and help “grow” earnings per share.
While IBM was busy laying employees off, cutting costs, and repurchasing shares, one of its biggest competitors going forward (Amazon) was busy reinvesting into its business.
The chart below shows the amazing rise of Amazon’s R&D spending over the last decade. Amazon’s R&D went from $451 million in 2005 to a whopping $9.3 billion in 2014. Over that same time period, IBM’s R&D spend fell from $5.8 billion in 2005 to $5.4 billion last year and has slightly decreased each of the last three years.
Once again, we can see Amazon’s commitment to R&D outshining IBM’s investments by a landslide. This chart shows the trailing 5-year compound annualized growth rate (CAGR) of R&D spending for each company. Amazon’s R&D CAGR has accelerated from 31% in 2010 to 50% in 2014, while IBM’s 5-year R&D spending has contracted on an annualized basis each of the last three years. YTD in 2015, IBM’s R&D expenditures are down 6% compared to the same period during 2014 as well.
Some of you are probably thinking that Amazon’s higher R&D spending rates make sense because it is enjoying so much more sales growth. This chart shows R&D as a percentage of total sales for each company. Once again, Amazon’s commitment to innovation shines through. From 2005 through 2011, IBM actually spent a greater proportion of sales dollars on R&D than Amazon did. Since then, Amazon’s rate has nearly doubled while IBM’s has consistently eroded since 2005.
With Amazon spending over $4 billion more per year on R&D than IBM and many competitors being forced to follow suit, IBM has some serious work to do if it wants to be a force in the fast-moving “strategic areas” it has identified – cloud, mobile, social, analytics, and security.
It remains to be seen if IBM can maintain its current rate of R&D spending while staying competitive in its legacy markets and also beating out competitors in areas such as cloud and analytics. If the company continues pinching pennies and takes its focus off of its core business, profitability concerns could be the next major concern to crop up and hit the stock. IBM might also have to step up its R&D expenses to remain competitive, further pressuring earnings.
Fortunately for IBM, its legacy cash cows (mainframe-related hardware, software, and services) seem like they will continue generating nice profits for years, if not decades, to come. It just won’t provide any growth as it slowly erodes – thus the need for the company to reinvent itself while profits continue flowing in from “old tech” businesses.
Mainframes are typically built for mission-critical applications that require total reliability and security. Many customers are in risk-averse industries like banking and insurance and are unlikely to switch away anytime soon, if ever. They face high switching costs because many of their business applications running on mainframes have years of old programming code and logic built into them, representing major investments of time and money. From a cost perspective, mainframes do have a much higher up-front cost than servers, but given the right workload they can actually deliver a lower total cost of ownership compared to using a sprawling server farm. Simply put, many large companies will not move all of their business processes to the public cloud.
As seen below, free cash flow generation is no problem for IBM and won’t be for the foreseeable future:
IBM’s “strategic areas” of cloud, mobile, social, analytics, and security accounted for 27% of the company’s revenue in 2014 and grew 27% in Q3, excluding foreign currency effects. At the start of the year, IBM planned to invest $4 billion in these initiatives in 2015 with a goal of increasing their revenue from $25 billion to $40 billion by 2018. The company certainly has some interesting technologies, including its own cloud infrastructure service called SoftLayer and a cognitive computing business.
The jury is still out on IBM’s ultimate success in these areas, especially since the company appears to be late to the game in many cases. During Q3, Amazon reported that its Amazon Web Services business grew revenue by 78%, underscoring the pace at which cloud services are impacting traditional hardware and services revenues generated by big IT vendors such as IBM. It’s hard to imagine IBM competing with Amazon’s cloud services on price, so it will need to find other ways to win.
While it’s far too early to evaluate the effectiveness of IBM’s ongoing investments to stay relevant, we can scrutinize its dividend.
While IBM is not yet a dividend aristocrat, the company has raised its dividend for 20 consecutive years and shows no signs of stopping. IBM’s payout ratio is less than 35% on a trailing 12 month basis, leaving it with plenty of flexibility for growth. As seen below, IBM has grown its dividend at a double-digit annual rate over every time period during the last decade.
IBM trades at 9x forward earnings estimates and has a 3.8% dividend yield. If the company can return to sustainable sales and earnings growth, it is clearly a bargain.
Accurately forecasting turnarounds is hard enough, and IBM’s case is particularly complex given its dependence on fast-changing, very competitive technology markets for future growth.
IBM is a massive company. Change takes time to play out. The stock could very well turn out to be a big winner over the next five years, but its culture issues and questionable management decisions over the past decade make it equally likely to be a value trap in our view.
For now, we are happy to watch from the sidelines for some validation that IBM can be competitive and profitable in the strategic areas it is growing into. Missing the first 20% rally from the bottom is a risk we are willing to accept if it means that IBM’s chances of successful reinvention have become much higher, reducing the likelihood that our investment becomes a value trap.
IBM has proven to be a durable giant over its more than 100 years in business. Despite the stock’s disappointing performance over the past several years, the company continues throwing off mountains of free cash flow that can be used to drive growth in strategic areas of focus. Whether or not IBM’s current management team and culture can execute is a different question. The track record is not good, but the market is also giving them very little credit in the stock’s price today.
For investors living off dividends in retirement, IBM’s 3.8% yield is very safe. Dividend growth should easily outpace the rate of inflation going forward as well. While no one knows if or when IBM will get through the challenges currently impacting the business, you can perhaps sleep a little bit better knowing that Warren Buffett continues to find the stock attractive.
For now, given the state of the company’s culture, the “me too” nature of management’s strategy, and the rapid pace of change in markets such as the cloud, we will wait to see some clearer signs of fundamental momentum before getting too excited.
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