Saturday, February 1, 2014

Will IBM hit its own Guidance in 2014?

To believe or not to believe, that is the question facing IBM  $IBM shareholders. IBM's fourth-quarter results were not well received, as they pointed toward weakening trends in its business. However, management's outlook for 2014 puts the stock at an attractive forward valuation. If IBM hits guidance, you can feel confident the stock will go higher, but will it make those numbers?

IBM delivers positive guidance
Stopping for a second and putting the 2014 guidance into its appropriate context would demonstrate just how cheap IBM is:

  • Guidance of non-GAAP earnings per share, or EPS, of $18 implies a forward P/E ratio of around 10 times earnings

  •  Free cash flow guidance of $16 billion in 2014 implies that IBM will generate 6.9% of its current enterprise value (market cap plus debt) in free cash flow

  • Non-GAAP EPS guidance of $18 implies a 10.6% increase from this year's $16.28 despite the tax rate rising from 16% in 2013 to 23% in 2014

  • IBM's management reiterated its long-term forecast of $20 of EPS in 2015

These are impressive figures and growth assumptions by any standards, and somewhat startling when you consider that IBM's Non-GAAP gross profit actually decreased by 4.9% to $14.6 billion in the fourth quarter. Furthermore, its revenue growth has been disappointing this year.

IBM's slowing growth                         
A chart of IBM's segmental revenue growth reveals how lackluster its growth was in 2013.

Source: IBM Presentations.

The underperformer is obviously its systems and technology (hardware) segment, which suffered in 2013 due to its System Z mainframe maturing in its product cycle. Furthermore, IBM's management cited "challenges in our hardware business model specific to power, storage, and X86." All told, IBM made a pre-tax loss of $507 million on systems and technology in 2013.

If this wasn't bad enough, IBM's management predicted the hardware segment would be flat in 2014. Furthermore, the segment is inordinately hit by its weakness in China. Although other companies have reported slowing growth in China, IBM's major rival, Oracle  recently reported "good growth" in China. In fact, Oracle's own hardware systems sales came in at the high end of its guidance, only declining 2% versus guidance of -1% to -9%.

All told, IBM does appear to be underperforming with its hardware business, therefore the intended $2.3 billion sales of its x86 servers business appears to be a good move. Incidentally, the benefit from this sale is not included in IBM's forecast being discussed in this article.

Software and Services to the rescue
One of the big themes behind IBM in recent years has been its willingness to forego revenue growth in favor of profit and free cash flow generation. However, IBM needs to do more than this now. If it's going to hit the targets outlined above, it will need to successfully execute its plans for software.

Its software segment was responsible for 48.3% of segmental profits in 2013, but profit only grew 2.7% on the year. IBM's plans involve shifting its revenue toward areas like big data analytics, cloud computing, and security. In fact, management described its big data analytics business as being responsible for $16 billion in revenue (its original target for 2015), and has now taken its 2015 target to $20 billion. Meanwhile, its cloud solutions revenue grew 69% to $4.4 billion, and it continues to invest in software centers in order to expand its reach.

All told, IBM does have growth initiatives, but considering that its software profits grew slowly last year, it's tough to see how it can rely on software alone. Moreover, global business services profit (14% of total segmental profits) only grew 7.7%, and global technology services (30%) grew a paltry 0.3%.

So how exactly is IBM going to hit its aim of $18 in earnings?

Growth in 2014
The answer to this question comes from a variety of sources which IBM's management discussed on he conference call:

  • Growth from big data analytics, cloud computing, and security will replace slowing growth elsewhere

  • IBM is taking workflow rebalancing in the first quarter, which will reduce earnings in the quarter, but cut costs later in the year

  • More additional benefits from the rebalancing taken in the second quarter of 2013

  • Currency could prove less of a headwind in 2014, as management believed that currency cost IBM "as much as $600 million on a pre-tax basis" in 2013, equivalent to around 3% of full-year pre-tax income

  •  The second and third quarters will have easier comparisons from weak results in 2013, particularly in hardware

  • Its strong free cash flows can be used to repurchase stock and push earnings per share higher

Will IBM hit guidance?
On the negative side, its earnings reports were weaker than expected in 2013, and there is a fear that its focus on hitting its target of $20 in EPS in 2015 is hurting the quality of its earnings. In other words, it may be cost-cutting and pruning just in order to hit its guidance growth, but these actions may result in making revenue growth harder to generate in future.

On the positive side, a lot of what IBM needs to do involves internal execution (workflow rebalancing, cutbacks) and investing in areas (cloud, big data, security) that are already growing strongly. Moreover, IBM has a long-term reputation for hitting guidance, and its divestitures and investments all make logical sense. There is a good case for giving its management the benefit of the doubt.

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