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Tech bellwethers Cisco Systems, Inc. and International Business Machines Corporation have much in common. Both are superficially very cheap stocks, but as usual in such cases, significant questions exist over their strategic futures. What is the market afraid of, and are they worth buying on a risk/reward basis? Let's take a look.
Going cheap
Both stocks look cheap, with dividend yields of around 3.6% and free cash flow generation that suggests they could pay much more. In addition, if you look at enterprise value (market cap plus net debt) to free cash flow, the stocks are worth buying even if they only grow earnings in line with inflation.
Another set of earnings meant another disappointment for Oracle shareholders. Earnings, revenue, and key performance metrics all came
in toward the bottom end of guidance, and Fools must be wondering just
how reliable Oracle's guidance actually is? However, the company also
made some reporting changes that should make its earnings easier to
follow in the future, yet most of these adjustments simply reflect a
change in industry-end demand.
In common with its main rival IBM , Oracle is shifting its efforts toward areas of growth such as cloud
infrastructure. The question is, how will Oracle's new guidance help
Fools to better follow the company?
IBM's management used its recent investor day to affirm its commitment to
its target of $20 in earnings per share by 2015. Usually, this sort of
news meets with a favorable response from the market, but the sell-off
in the stock indicates that investors have some concerns. Not only does
IBM have a lot to do to hit the target, but it's relying on its growth
initiatives in areas where it faces increasing competition from rivals
such as Oracle and Microsoft. So what do you need to know about IBM's strategy to return to growth?
IBM's skeptics multiply Investment analysts tend
to produce estimates that come pretty close to management's guidance or
slightly above it. This fact makes the consensus forecast for IBM's
2015 earnings of $19.81 all the more interesting. As a group, they don't
believe IBM will hit the number, and the following points mark why they
might be skeptical. I'll start with a breakout of how IBM's segment
revenues have grown in recent years.
It's easy to criticize Wall Street for being too myopic and focused on near-term targets, but is IBM doing this too? IBM has laid out a specific set of metrics that it
intends to hit, and it could be forcing its management to damage its
long-term business development by hitting them. It's time to look more
closely at what's going on at IBM, and whether its underlying business
is being compromised or not.
Why IBM disappointed in its first quarter It's
no surprise that the first quarter conference call saw analysts asking
question after question regarding how IBM intends to hit its targets.
After all, the company's management has laid them out repeatedly, and
appears to want to be judged by them.
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.
Investors in Verint Systems and its rival NICE Systems
have gotten used to some pretty solid performances in 2013. The two
companies specialize in systems that capture and analyze customer and
employee interactions. With the growth in data analytics that companies
like NICE's partner IBM
is seeing, you can expect both Verint and NICE to find it a lot easier
to sell analytics as part of their packaged solutions (which is exactly
what is happening.) Moreover, the shift toward analytics looks likely
to favorably adjust their long term growth rates.
Verint Systems beats and raises The recent third quarter results from Verint saw the company beat estimates and raise guidance.
The full-year revenue growth forecast was increased to 6.5%-7.5%, up from 6%-7% previously.
Full-year EPS guidance was raised to $2.75-$2.80.
2015 revenue and diluted EPS guidance were projected at of 7%-9% growth.
Verint differs from NICE by focusing more on
security and government work, while NICE's strength lies in the
enterprise (particularly in the financial sector) and call center
markets. As such, the two Israeli companies will inevitably be discussed
as merger candidates. The differences also mean that they report some
contrasting results at times. Looking at Verint's quarter in detail, the
standout performer was Verint's communications intelligence segment
which recorded 30.6% revenue growth.
Source: Company presentations
If there was a disappointment, it was with the 3.3%
rise in enterprise intelligence revenue. Verint's management argued
that this was a consequence of weakness in Europe, because its Americas
enterprise business was up "mid to high single digits."
NICE and Verint grow data analytics Both
companies are seeing growing analytics sales. The two already have an
installed base of clients with their hardware solutions, so it's
relatively easier for them to sell larger deals with analytics
incorporated into the deal. Indeed, this is part of the reason why IBM
has a deal with NICE, that involves incorporating its big data analytics
within NICE's solutions.
The big advantages enjoyed by these companies is
that their customers get to buy analytics and customer interaction
capture systems (voice, video, online, and similar options) from one
vendor. However, Foolish investors should note that the shift is
changing some of the operating metrics.
Verint confirmed that it is seeing stronger average selling prices as its solutions are increasingly being sold with analytics.
Sales cycles appear to be getting longer as deal size and complexity increases.
Solutions that include analytics software are likely to see a
trade-off between short-term revenue generation and longer-term service
and support revenue.
Margins and cash flow should improve going forward as software tends to be higher margin.
Many of these factors are already playing out in Verint's
results. During its conference call, Verint's management outlined that
its operating cash flow would be around $160 million for the full year,
and "we expect that cash flow to grow kind of commensurate with the
earnings growth that we outlined in our guidance." Assuming capital
expenditures of around 1.8% of revenue (a conservative estimate)
suggests that free cash flow generation will be around $144 million and
$154 million for the next two years. These are impressive figures,
especially given that its enterprise value (market cap plus debt) is
only $2.28 billion.
Eagle-eyed readers will note that Verint's guidance implies no
increase in margins next year, despite it selling more software
analytics solutions. When pushed on the issue on the conference call,
CEO Dan Bodner replied:
Our guidance is 7% to 9%... ...we are aiming at double-digit growth.
So the trade-off here is between leverage that obviously exists in the
software business and investing more organically to accelerate growth.
And at this point, this is our initial guidance.
In other words, don't be surprised if Verint trades off its margin
expansion in the near-term to generate stronger growth in future.
The bottom line In conclusion,
this was a pretty strong report from Verint. Along with NICE Systems,
it represents a relatively cheap way to play the big data trend. These
companies aren't over-researched glamor stocks, and I think this makes
them even more interesting for Fools to look at. With a P/E ratio of
13.4 times 2014 estimates, Verint remains a good value.
Shareholders in Cisco Systems
saw their investment crash after lackluster first-quarter results. The
stock is now down around 20% from its yearly high in August. With the
mid-point of its 2014 guidance implying a 1% fall in earnings, is now
the time to give up on the stock, or to buy in?
Cisco's nasty quarter Cisco
beat earnings estimates for the quarter but missed revenue expectations,
and its near-term outlook is horrible. Its orders in the quarter were
$600 million -- $700 million short of its own expectations -- a problem
for a company with 70% of product revenues dependent on new orders each
quarter. With this shortfall in place, its second-quarter EPS guidance
of $0.45-$0.47 came in nearly 8% below analyst estimates at the
mid-point.
There are two key problems.
First, Cisco basically repeated what IBM said earlier in the earnings season
with regard to demand in emerging markets. Both companies had reported
some second-quarter weakness in the BRICs, but IBM's disclosure that its
Chinese sales declined 22% in the third quarter -- with hardware down
40% -- was a big surprise.
Fast-forward to Cisco's third-quarter results, and
the weakness seems to have spread out. Here is CEO John Chambers on the
subject:
Every one of our top 10 emerging countries missed
their forecast and was off by a fair amount. So it wasn't just that it
was down, the last couple of weeks, they kept dropping and dropping...
... it was over half of our shortfall, the last couple of weeks versus
forecast.
Frankly, it's puzzling as to why Cisco's
performance in emerging markets was so weak across the board. China was
down 18% -- in line with what IBM reported -- but why should Russia and
Brazil be down 30% and 25%, respectively?
One possible answer can be construed from something
that CEO Chambers mentioned in the conference call. He argued that
Cisco went into the last month of the previous quarter "a little bit off
the numbers we expected." But in the last two weeks of the quarter, its
orders came in $300 million more than forecast. It's possible that
Cisco's emerging market weakness was exacerbated in this quarter because
in the previous quarter its sales people pushed hard to make the
numbers.
The second issue was the 14% fall in
service-provider video revenues, while orders also disappointed with a
13% decline. Cisco's set-top box sales declined 20%, and since they make
up 20% of revenue from service providers -- which makes up more than 8%
of total revenue -- the impact was significant. Cisco's challenge is
to manage the transition from traditional set-top boxes toward its
set-top boxes that connect with the cloud. In fact, this has been an ongoing issue
this year. It seems that sales of its new products were disappointing,
and Cisco continued to follow a policy of "walking away" from low-profit
deals with the older technology. Good for margins, terrible for revenue
growth.
Four reasons to stay positive? If you can see a clear pathway through the gloom and doom, there are four reasons why the stock looks attractive.
First, Cisco described its U.S. enterprise and
commercial growth as being very strong and cited order growth in the
high single digits. This matches what Oraclesaid at its earnings in September.
Oracle saw its new software-license and cloud subscriptions rise 14% in
America. This is a sign that the U.S. -- particularly in enterprise --
is the standout region for IT spending growth. It's a good sign for U.S.
growth.
Second, the set-top box issue is a structural
problem, but Cisco is managing it, and has products in place. Further,
plenty of IT companies see some issues when they introduce new products
or make transitions in technology. Companies can be reticent to spend on
an old system when a new one is available, yet also careful not to rush
to buy and integrate a new technology. However, provided the underlying
demand is there, these issues can be sorted out in a few quarters. For
example, tech companies like F5 Networks and Check Point Software have seen these issues over the last year.
Third, Cisco was obviously disappointed with its
performance in emerging markets, particularly late in the quarter. This
means it's likely that the updated guidance has been reset with current
trading in mind. If BRIC spending picks up, then Cisco could surprise on
the upside going forward. In any case, emerging-market demand does tend
to be volatile.
Finally, the company has $48.2 billion in cash and
cash-like investments, while total debt is only $16.2 billion. In other
words, its net cash of $32 billion represents around 29% of its market
cap. Cisco has the resources to make earnings-enhancing acquisitions.
Time to buy Cisco? Cisco is
going to attract value hunters. Even on its disappointing $1.95-$2.05
EPS guidance, the stock still sells at a P/E ratio of around 10.5 times
forward earnings. It's not the highest-quality technology company out
there, but it's cheap, and it has opportunities to turn around its
fortunes. Throw in a near-3% dividend yield and you can enjoy some
income while you wait.
A slightly disappointing set of results from customer interaction specialist NICE Systems (NASDAQ: NICE)
must have left its investors fearing that growth is starting to slow
for the company. The company's non-GAAP revenue growth slowed to just
4.2% in the quarter. Is it time to give up on the stock?
NICE Systems lowers guidance A brief summary of the third-quarter results and outlook:
Non-GAAP Revenue of $230.1 million vs. guidance of $225 million- $240 million
Non-GAAP EPS of $0.62 vs. guidance of $0.56-$0.66
Fourth-quarter revenue guidance of $260 million-$275 million
Fourth-quarter non-GAAP EPS guidance of $0.72-$0.77
The fourth-quarter guidance means that the
company's full-year guidance is now $940 million-$955 million, which
represents a lowering of the high end by $15 million. Similarly, the
high end of its full-year EPS guidance was lowered by $0.05 to reach
$2.55-$2.60.
Data analytics demand is slowing revenue growth
While it's never a good thing to see companies lowering guidance, NICE
has some plausible reasons for doing so. In addition, they mirror what
its competitor, Verint Systems (NASDAQ: VRNT)
, is delivering. Both companies specialize in selling systems that
monitor and analyze customer interactions. Moreover, increasing
awareness of the need for corporations and governments to use data
generated from user/customer interactions is creating more demand for
analytics solutions.
The good news is that increasing analytics sales
should drive stronger cash-flow generation in future because they tend
to be higher margin. The bad news is that it has a negative effect on
near-term revenue growth. Deals with analytics solutions tend to have
longer sales cycles, which means they generate revenue over a longer
time period due to having a larger services component.
A quick look at NICE's products and services demonstrates that its services growth is much stronger these days.
Source: company presentations
In addition, in its last set of results,
Verint disclosed that it was signing larger orders this year, with much
higher growth rates from its analytics solutions. Turning back to NICE,
here is what its management said on the recent conference call:
In the third quarter, new order of advanced
applications grew well above 20% compared to the last year's third
quarter and represented close to 50% of total new bookings.
Verint and NICE are both seeing sales moving toward value-added analytics solutions.
Reasons to be optimistic Looking forward to the next quarter, investors shouldn't be worried by the lowering of guidance for the full-year.
First, NICE's management confirmed that it was
targeting year-on-year growth in its product revenue. This would be a
welcome return to form because product revenue growth has been negative
for the last three quarters.
Second, management claimed to be on track for over
$1 billion in bookings this year. When you consider that the midpoint of
its full-year revenue growth is $948 million, it's clear that bookings
are growing faster than revenue. This is fine because the service
revenue from these bookings will drop into the top-line over time.
On a more negative note, there was some weakness in the enterprise sector in China and India. Given what NICE's partner, IBM (NYSE: IBM) recently reported in China,
this wasn't surprising. NICE incorporates IBM's analytics solutions
within its services offering. Unfortunately, IBM's management doesn't
expect to return to growth in China until the first quarter of 2014.
While this is disappointing, it should be noted that IBM's business
analytics solutions were the brightest spark in its recent results, and
are still up 8% year-to date.
Where next for NICE Systems? All
told, it was a solid, but slightly disappointing quarter from NICE.
Looking ahead, it needs to hit its targets in Q4, and then outline a
faster pace of growth in 2014. Analysts have NICE on 8.8% revenue growth
in 2014, but given the structural changes in its revenue stream
discussed above, it's reasonable to expect forecast be lowered.
The slowing of revenue growth is not a problem in
itself, provided that NICE continues to generate good bookings growth
and strong analytics sales. Companies will always find it difficult to
predict revenue growth when the structure of their sales is changing in
this manner.The bottom line is that the company's cash flow remains very
strong, and with a P/E ratio of just 13.7 times forecast for 2014, the
stock is a good value.
There are two key conclusions to be drawn from International Business Machines' (NYSE: IBM)
recent results. First, for the third quarter running, they were
disappointing, and second, the stock is still cheap. Growth-oriented
investors probably won't be turned on by such considerations, but
value-based speculators may see IBM as too good to pass up.
IBM disappoints, but reaffirms targets To put these results in context, here is a graph of its major business segments.
Source: company accounts.
Clearly, the last six quarters have been difficult
for revenue growth. However, it is understandable because IBM's focus
has been on exiting lower-margin businesses and focusing on reshaping
the business toward higher-margin software and services sales. Moreover,
its stated aim is to hit $16.90 in non-GAAP adjusted EPS for 2013, and
ultimately hit $20 in EPS by 2015. Eagle-eyed readers will note that
these earnings would put IBM on P/E of 10.2 and 8.8 times its 2013 and
2015 forecasts, respectively. Since management reinstated these targets,
should investors just ignore the falling revenue and buy a cheap stock?
Believing the numbers Ultimately,
your decision will boil down to how much you believe in the numbers.
The latest evidence suggests that the underlying picture is getting
murky.
Diluted EPS rose 10.5% in the quarter, but pre-tax income actually
fell 5.2%. The difference is due to a large reduction in the tax rate.
Buybacks played a part, too. If you assume that the tax rate and
share count remained constant, IBM's EPS actually fell 5.2% for the
quarter.
Last quarter, IBM predicted low single-digit growth for its global
technology services, or GTS, but they came in at -1% on constant
currency basis.
Last quarter's weakness in the BRICs continued, with Chinese sales
down 22% (with hardware sales falling 40%) and they are not expected to
grow again until the first quarter of 2014.
The weakness in software continues, with sales up just 2% in
constant currency. Indeed, last quarter's strength was arguably due to
rollover deals that were delayed from the first quarter.
In fact, the only segment that really performed
well was its global business services segment, or GBS, which delivered
constant currency sales growth of 5%. This was in-line with IBM's
forecast of mid single-digit growth.
All told, this was a weak quarter for IBM. In common with its major rival, Oracle (NYSE: ORCL)
, IBM reported good growth in business analytics (up 8% year-to-date)
and proudly trumpeted that it delivered $1 billion of cloud revenue in
the quarter.However, cloud revenue only represents 4.2% of total sales,
and the strength in business analytics highlights the fact that there is
growth in IT spending, just not in the areas where IBM gets most of its
revenue.Trends in software spending clearly favor software as a service
companies like Salesforce.com (NYSE: CRM) .
Comparing IBM with Oracle The
analogy with Oracle is a strong one. Both are highly cash-generative
tech giants with cheap valuations. Both are facing some structural
challenges to their hardware offerings due to an increasing willingness
among firms to outsource technology infrastructure to the cloud. As
usage of software as a service, or SaaS, increases, hardware margins
could come under pressure for IBM and Oracle because corporations will
not need to buy hardware systems to run their on-premise on-license
software. In their defense, IBM and Oracle are trying to migrate toward
cloud-based solutions, but it's going to take time to work through the
pressures on their existing sales.
However, there is one key difference between the
two companies. IBM has set its stall out to achieve the $20 EPS target
in 2015, while Oracle has much more flexibility to adjust to changing
market conditions. It's good for IBM to laud the $8 billion it used to
make buybacks (and there is still $5.6 billion remaining in buyback
authorization), but investors surely wouldn't want the company to rack
up debt just to hit the $20 EPS target. Moreover, IBM may be using
resources that it could instead use to make strategic investments in
growth opportunities.
How the Salesforce.com deal demonstrates Oracle's flexibility IBM's
net debt stands at nearly $27 billion (14.3% of its market cap), while
Oracle has $15.2 billion (10.1% of its market cap) in net cash and
liquid instruments. Simply put, Oracle is in a better financial
position to make the kind of game-changing acquisitions that can help
accelerate SaaS-based growth.
Moreover, with its recent strategic partnership
with Salesforce.com, Oracle is demonstrating its willingness to work
with a former rival. With Oracle now integrating Salesforce.com into its
infrastructure, its mutual customers should benefit from being able to
use Oracle infrastructure to run Salesforce.com's CRM applications,
while also using Oracle's financial and HR applications. The deal should
provide synergy for both companies.
The bottom line Cost-cutting, buybacks, and
foregoing revenue growth at the expense of profit growth are noteworthy.
However, IBM is going to need a couple of solid quarters in order to
convince the market that its long-term earnings objectives aren't
affecting the way it reacts to changing market conditions. This is the
third quarter in a row in which IBM has given disappointing results, and
the company is running out of excuses.
In a sense, the initial market reaction to Intel's (NASDAQ: INTC) latest results tells you what you need to know about the stock. In short, the semiconductor manufacturer gave lower than expected revenue guidance, declared that its customers were cautiously keeping their inventories lean, and delayed production of a new chip due to technical issues. Yet, the stock still went up.
Intel disappoints Intel's third-quarter revenues of $13.5 billion were in line with company guidance and its gross margins were higher, but this was far from being a positive report. Essentially, the chipmaker is trying to transition its products toward ultra-mobile PCs and mobile devices. Meanwhile, it has to deal with the usual uncertainty of its end demand that bedevils the highly cyclical semiconductor sector. There are four key takeaways from the results, and each of them highlighted Intel's current difficulties in achieving its aims.
First, the midpoint of Intel's revenue guidance for the fourth quarter implies that full-year revenue will come in at around $52.6 billion. This represents a year-on-year decline of 1.4%, when it had previously forecast they would be flat.
Source: Company accounts.
The main reasons appear to be that its customers are reluctant to build up inventory due to uncertain consumer demand. Indeed, only a day later Taiwan Semiconductor (NYSE: TSM) said its fourth quarter revenue could fall by 11%, due to "softer demand for certain high-end smartphones and inventory correction." This is a worrying comment given that the fourth quarter is traditionally the strongest for the industry.
Second, Intel argued that its mature markets in the US and Europe were stabilizing, while Asia and particularly China remained volatile.
The third takeaway is that production of its 14 nanometer chip Broadwell will now begin at the start of 2014, one quarter later than planned. On the conference call, management claimed that this was "a small blip in the schedule" due to a technical issue which has now been resolved.
Fourth, Intel announced that its Bay Trail processor (aimed at the entry point ultra-mobile device market) had over 50 design wins, and eight to ten of these products will be available by Thanksgiving.
What it all means: FedEx, International Business Machines, and Intel
From a macro perspective the color given on its customers' behavior was disappointing, but it's in-line with what other bellwethers have been saying. For example, FedEx has sequentially lowered its global 2013 GDP forecast throughout the year. In addition, International Business Machines (NYSE: IBM) recently reported weakness in China. IBM's sales were down 22% in China, with its hardware sales down a whopping 40%. IBM blamed a combination of its own execution problems, and delays in public spending caused by the wait for the mid-November release of an economic reform plan. Moreover, IBM doesn't expect Chinese demand to improve until early next year. A warning sign for Intel's fourth quarter?
With regard to its internal execution, Intel's scorecard is mixed. The technical issues with Broadwell appear to be resolved, but the delay now means that products incorporating the chip won't be available until after April. In addition, the design wins with Bay Trail are impressive, but investors could have hoped for more products to be available during the critical shopping season.
All told, it's not hard to see why the full year guidance was lowered.
But does it really matter?
The fact is that none of these developments represent significant long-term headwinds for Intel. The technical issues with 14 nanometer chip production only serve to highlight that next generation chip production requires huge resources, and very few companies have Intel's financial firepower. Furthermore, Intel is now demonstrating its commitment to penetrating the ultra-mobile device market.
Despite the fall in earnings this year, the stock still trades on a P/E ratio of 12.7 times earnings for 2013, and a dividend yield of nearly 4%. In other words, the valuation is so cheap that Intel can afford to make the odd hiccup from quarter to quarter. Moreover its near 60% gross margins and substantive free cash flow generation (approaching $9 billion on a trailing basis) mean that it can buy its way into the new device market. The company may not be firing on all cylinders, but the valuation provides for plenty of upside if/when it starts achieving its aims.
If you favor a value-based, long-term, buy-and-hold investing
strategy, then you must have noticed how cheap some blue-chip tech
stocks are right now. The easy move is to put a bunch of them in your
portfolio and forget about them for 10 years. Unfortunately, tech
investing is rarely that easy. So what do you need to know before making
a decision?
Tech titans First up, let's look at a chart of these tech titans. I've included a mature blue-chip stock, Johnson & Johnson
by way of comparison. Enterprise value over earnings before interest,
tax, depreciation, and amortization, or EBITDA, is used, because EV --
market cap plus net debt -- is a better measure to compare companies.
Moreover, EBITDA is a good proxy for underlying cash flow.
All these companies look relatively cheap. Moreover, on a historical basis they are all a good value. In fact, Intel (NASDAQ: INTC) , Oracle (NYSE: ORCL) , and Cisco (NASDAQ: CSCO) are all trading at substantial discounts to their pre-recession valuations. Why is IBM (NYSE: IBM) the odd man out?
Adjusting early to structural shifts IBM adopted a
different strategy to the rest. It acted early to adjust to structural
changes in the economy. The sale of its PC division to Lenovo in 2004
was a key part of its transition into primarily a software and services
company.
Source: Company accounts
Consider how well Oracle's stock performed compared to Intel and Cisco over the last 10 years.
The charts demonstrate that over the last decade, goods, products,
and services have commanded higher prices based on how "smart" they are.
For example, think of the advanced electronics systems being fitted
into cars, or smartphones versus landlines. The shift is mirrored in the
outperformance of the one software and services company on the list:
Oracle. IBM also did very well, precisely because it made the transition
to selling more software and services.
Going forward, IBM's strategy is to sell its lower-margin businesses,
and increase margin expansion at the expense of revenue growth.
So while its revenues are forecast to be flat from 2012-2014, its EPS is expected to rise 20%.
Oracle now facing challenges The previous 10
years have been very good for Oracle shareholders. However, there is no
guarantee that the next 10 will be the same. The company remains a very good value play,
but it also faces its own structural challenge with its traditional
on-premise, on-license sales being threatened by cloud-based software
providers. Moreover, as cloud-based sales increase, Oracle will find it
harder to bundle its hardware solutions with its software.
Accordingly, analysts have Oracle on low-single-digit revenue growth
for the next couple of years, with only high-single-digit earnings
growth forecast. Oracle is seen as being late to the cloud party, and
its future growth depends on making the adjustment.
Intel adjust its business, Cisco tinkers Intel is
the worst performer of the four, and it's also facing some structural
challenges. It wasn't the only company caught out by the acceleration in
mobile computing at the expense of PCs. Subsequently, Intel has found
its core PC processor market to be challenged as PC sales repeatedly
disappoint, and ARM core processor designs have won out
in the mobile market. Simply put, Intel's refusal to license ARM's
architecture in a meaningful way, has hurt the company.
The good news is that Intel has invested in new processors (Bay Trail
and Haswell) that should start to penetrate the ultra-mobile market as
of this year. Intel will need to do this in order to hit guidance this year.
Cisco's challenges and opportunities are of a different sort.
It's switching and routing divisions still generate low-single-digit
growth, but it's not enough to get excited about the company. Moreover,
its services revenues growth -- services make up around 21% of total
revenues -- is really a function of how well it can sell its products
into the marketplace. The real question is how well Cisco will invest
its cash in growing its peripheral sales.
You can see the point illustrated in the following chart.
Source: Company accounts
What you need to look for Intel will become very
attractive if it can establish a strong foothold in the mobile market.
You'll want to monitor developments later this year.
Oracle needs to halt declines in its hardware sales and demonstrate
that it can shift more revenues to the cloud while retaining margins
with its traditional software. However, the stock is very cheap right
now, and even stabilizing the company to GDP-type growth should see some
good price appreciation.
IBM's story is one of ongoing margin improvements and the execution
of its plan. Look for margin expansion. Cisco is intriguing because its
sits on more than $34 billion in net cash and investments, while its
market cap is $123 billion as I write. In other words, it has the
capability to invest wisely and generate growth. Keep an eye on its
acquisition strategy.
Each of the four has its own risks and rewards, but a portfolio that contains all four isn't a bad idea for a value investor.
Oracle (NYSE: ORCL)
is one of the most tempting cash-rich plays in the market right now.
The company has an undoubtedly cheap valuation, but is it a long-term
value trap in the way that Dell or Hewlett-Packard (NYSE: HPQ)
have been over the last five years? Moreover, is its current
low-single-digit growth rate signaling the endgame of its relevance as a
growth company?
It's the cash-flow, stupid
Investing
is supposed to be easy. Take a stock like Oracle, which just generated
$14.1 billion in free cash flow over the last four
quarters--representing more than 10% of its enterprise value. In other
words, if you hold the stock for 10 years, even with no growth,
the company will have generated enough cash to buy you another Oracle
for free. Furthermore, it can return that cash flow to shareholders by
increasing its dividend, buying back stock, or increasing earnings
through acquisitions. Sound good?
And that's assuming no growth, when the reality is
that Oracle's forecast revenue growth rates for the next few years are
pretty close to nominal GDP growth.
Why this isn't a no-brainer Superficially, this isn't a hard choice to make, but the market seems to be making some harsh conclusions about Oracle:
The market does not reward tech companies if they cannot generate
growth, and you can stay waiting ages for "good value" to be realized
Corporations are favoring cloud-based software, and Oracle's
traditional on-license, on-premise software will lose sales to providers
of software as a service, or SaaS, like Salesforce.com (NYSE: CRM) . It looks set for a structural decline just like Hewlett-Packard was.
The first concern is an existential
one, and older investors would do well to remember how the mentality of
the market changed after the dot-com bubble burst. During the bubble,
traditional valuations didn't matter, but after the burst suddenly
everyone remembered value. It doesn't matter if Oracle makes database
solutions or chicken tikka sandwiches; if it can return 10% of its
valuation in cash every year then it is good value.
The second is more problematic. It's easy to look
at Salesforce's near 30% growth rates, and conclude that Oracle is being
left behind in the shift to the cloud, but the fact is that Oracle does
have growing SaaS sales. The problem is that they are not enough to
counter slow growth in its traditional software sales. In addition, the
increasing use of SaaS solutions is reducing customers' need to buy
hardware, and negatively impacting Oracle's aim of selling hardware and
software systems to them. Indeed, Oracle's hardware system revenues
(around 14% of total sales) have declined for the last two years.
Hardware revenues are forecast to drop next
quarter. Even worse, Oracle predicted that its new software license-
and cloud-subscription revenue growth (20% of revenues, and the key to
growth) would be -4%-6% in the next quarter. Game over?
It would be a mistake to jump to a negative
conclusion. First, Oracle is up against a very strong comparison from
last year's second quarter for new license and cloud subscription sales.
Source: Company accounts
In fact, the second quarter was so strong last year that there appears to have been a pull-forward effect on the third quarter.
Second, Hewlett-Packard's problems were that its
core profit centers of printers, notebooks and desktops were in decline.
Its challenge was to restructure in the face of a systematic decline
in end demand. In comparison, Oracle's customers still want software;
it's just that more of them want it from the cloud. The company has the
cash pile and cash-flow generation to make significant acquisitions of
cloud based companies (such as its purchases of Taleo and RightNow), and
it's hard not to see it doing some more in future.
Third, there is an element of geographical effect
here. New software license and cloud software subscriptions grew 7% in
constant currency for the first quarter, but they were up 14% in the
Americas. This indicates that it's not necessarily a structural issue.
Where next for Oracle?
The
market looks like it's pricing in some severe problems for Oracle in the
future, but if things don't turn out as bad as many fear, then the
stock has significant upside potential. The company needs to stabilize
its hardware revenues while demonstrating willingness to invest in
cloud-based solutions. It could also do with a quarter or two of beating
the mid-point of its software sales guidance. These are not necessarily
high hurdles to overcome, and the reward of owning the stock could be
significant. Moreover, even if Oracle's growth does graduate into a
"GDP+" type of range, the stock still represents good value.
If there is such a thing as a defensive growth stock in the IT sector, then Verint Systems (NASDAQ: VRNT) might be it. Along with its rival NICE Systems (NASDAQ: NICE) , Verint has put in a very consistent performance this year. Both companies are leaders in customer-interaction and analysis solutions, and both look set for good earnings growth in the future. Verint recently followed NICE in reaffirming its 2013 guidance, and those of you looking for a relatively safe option within tech should consider the stock carefully.
End demand looks good...
The market reacted well to Verint's strong second-quarter results, even though it kept its full-year guidance unchanged. It was a similar story with NICE's second-quarter results delivered earlier in the reporting season. While the market may appear to be overly rewarding these companies for merely hitting guidance, there are deeper reasons why it is right. Essentially, there are a number of positive trends in the sector that help increase their longer-term earnings potential.
Customers are demanding more value-added data-analytics solutions.
Big data is starting to be used across all kinds of data channels, and companies will need to capture and integrate data from things like call centers, websites, social media, video etc.
Verint and NICE have strong, installed bases with their hardware-capture solutions, and they have an opportunity to sell data analytics into them because customers value buying solutions from one vendor.
Companies can still generate growth -- even in a weak economy -- by better analyzing their existing customers.
Solutions to prevent money laundering, fraud, and other crime are seeing secular growth prospects because criminals are also using technology to become more sophisticated.
Governments are increasingly pressured to use surveillance and intelligence gathering in order to monitor terrorist threats.
The points above relate to end-market demand, but the type of demand is also likely to positively change their earnings potential.
That demand is likely to help Verint's operating metrics
First, on its conference call, Verint predicted gross margins to be flat this year. You shouldn't read too much into this, because longer-term, the prospects for margin expansion are significant. Increasing demand for higher-margin analytics solutions implies that gross margins should increase in the future. Quoting from the recent conference call:
So overall, we still have about 50-50 mix between capture products and analytics. But clearly, we are growing our analytics portfolio. Analytics is growing at higher growth rates, which kind of shifts the overall growth rate of the company.
Verint is benefiting from analytics, and NICE has the bonus of a deal with IBM (NYSE: IBM) that integrates IBM's analytics solutions within NICE's solutions. This is a particular benefit to call centers and financials, sectors in which NICE is strong. IBM gets the benefit of tapping into NICE's installed base, and the latter gets to offer its customers the kind of analytical solutions that they require in the "big-data" world. It's a win-win scenario.
Second, even though it kept its full-year revenue-growth forecast at 6% to 7% and its EPS target at $2.75, the underlying picture did get better. Verint disclosed that it was seeing larger orders this year compared to last year.
What you need to understand is that these larger orders are likely to take longer to generate revenue, particularly if they contain a large services component. In other words, there won't be an immediate effect, but in the longer term, earnings and cash flow will be enhanced by booking larger orders now.
Where next?
Long-term prospects look good, and it's reasonable to expect margin expansion going forward. Moreover, if Verint and NICE can continue to grow revenues in the 6% to 7% range, then assuming an earnings growth rate in the double digits seems reasonable. Moreover, both companies are highly cash-generative. For example, Verint has converted more than 250% of its net income into operating cash flow over the last three years. This cash-flow conversion is likely to increase in future years as services and analytics grow as part of the revenue mix.
If NICE can hit free cash flow of around $125 million, and Verint hits its target of $100 million, then both stocks will trade on a free-cash-flow-to-EBITDA ratio of 5.9% and 4.3%. NICE looks cheaper on this basis, although both stocks look attractive for the long-term investor.
It’s been a volatile year for the tech sector, but one company's
consistency has helped it stand out. Customer interaction company NICE Systems(NASDAQ: NICE)
has managed to keep its guidance on an even keel throughout the year.
Meanwhile, the company is gradually transforming itself from a hardware
specialist into a big data play.
NICE Systems' latest results
Here's a brief summary of the company's latest-second quarter (Q2) results:
Q2 revenue of $225 million, vs. internal guidance of $220 million to $230 million
Q2 non-GAAP diluted EPS of $0.61, vs. internal guidance of $0.58 to $0.64
Q3 revenue guidance of $225 million to $240 million
Q3 non-GAAP diluted EPS guidance of $0.56 to $0.66
Full-year guidance maintained, with revenues forecast at $940 million to $970 million, and EPS of $2.55 to $2.65
The Q2 numbers were bang in the middle of internal estimates, while
full-year guidance held steady. In a year where so many other tech
companies have warned or reduced guidance, this must be seen as a net
positive. So why is NICE doing so well?
Reasons to be NICE
There are three key reasons why the company has been outperforming.
First, its solutions do not necessarily need a strongly growing
economy. Essentially, NICE enables governments and enterprises to
monitor and analyze interactions through call centers, websites, email,
or even internal company interactions (for compliance, fraud or
regulatory reasons).
Fortunately, these sorts of activities are equally relevant in a
slow- or a fast-growing economy. In fact, in today’s cautious spending
environment, corporations might be more inclined to maximize the
potential within their existing customers, rather than chasing new ones.
Second, big data is only getting bigger. The explosion of data being created by social networking sites such as Facebook is
creating a huge amount of awareness of the need for corporations to
monitor and analyze customer behavior. This benefits NICE, because it
may drive demand for its data-capturing hardware systems, and
also because NICE has the capability to sell data analytics solutions
into its installed customer base. NICE calls these solutions “advanced
applications,” and they made up a 50% of its new bookings in Q2.
Moreover, the company has been proactive in developing its offerings, thanks to a deal to incorporate IBM's (NYSE: IBM) world-leading
analytics solutions within its services. In exchange, IBM gets to tap
into NICE’s installed customer base (particularly its key financial
customers).
You can see the gradual shift in NICE’s revenues by looking at product sales vs. services sales.
Source: Company accounts.
The third reason is that a lot of NICE’s solutions are not really
economically aligned. For example, its financial crime & compliance
solutions increased an impressive 7% in Q2, and contributed 15% of
revenues. In addition, its security based revenues made up 20% of
revenues in Q2. In other words, 35% of NICE’s revenues are coming from sectors whose end demand is not really cyclical.
In addition, on its conference call, NICE outlined that
the Dodd-Frank act will likely increase financial companies' enforcement
and regulatory activity. This is good news for NICE, because financials
are likely to buy more compliance and monitoring solutions as a
consequence.
What the industry is saying
In general, the rest of the data capture and analytics industry has been reporting good market conditions. For example, despite reporting a mixed set of results in July,
IBM generated 11% growth from its business analytics solutions.
Meanwhile, NICE’s perennial rival and potential merger partner, Verint Systems(NASDAQ: VRNT), maintained its full-year revenue guidance of 6%-7% at its results in June.
Verint is a good potential partner, because its strength is in
security and government-based work, while NICE is stronger with
enterprises (particularly financial companies) and call-centers. Despite
reducing its guidance for its European operations, Verint’s overall
view on the first quarter was one of “particularly strong business
activity relative to the first quarter in the year.” In addition, Verint
reported similar business trends to NICE, with its analytics solutions
generating faster growth than its legacy capture systems.
Where next for NICE?
For the reasons outlined above, NICE has good chances to hit its
full-year guidance of around $2.60, putting the stock on a forward P/E
ratio of around 14.4 times earnings. That looks cheap for a business
with good long-term prospects, and relatively defensive growth
properties.
NICE has a tradition of good cash flow generation, having generated
an average of around $125 million in free cash flow over the last three
years. This figure represents around 6.2% of its current enterprise
value. In other words, there is plenty of scope to increase its dividend
yield of around 1.4%. Furthermore, the shift towards more services
revenues is likely to increase cash flow generation in future.
In conclusion, the stock represents a good way to get exposure to big
data spending, and is a good value proposition for more cautiously
minded tech investors. It could also see some upside if the market reevaluates it as a big data play.
One of the great IT bellwethers, IBM (NYSE: IBM),
issued mixed results in mid-July. It’s hard to be too critical of a
company that has just raised estimates despite increased currency
headwinds, but a deeper analysis of the company's results reveals some
underlying weakness. It’s been a difficult year for technology, and IBM’s earnings did little to raise investors' spirits.
IBM reports
The two key positives in the report came from the growth in
services backlog (7% at constant currency) and the strength in
higher-margin software sales. In order to demonstrate their impact, here
is a chart of IBM’s segmental growth. All data is sourced from company
accounts.
Growth in the second quarter was better than in the first. Moreover,
IBM’s reported revenue decline of 3% was made to look worse due to
currency headwinds of 2%. Based on its backlog, IBM forecasted that
third-quarter revenues in its global business services segment would be
up by mid-single digits, with global technology services increasing in
the low single digits.
The software segment's bounce back toward growth looked robust, and
management pointed out that its 4% reported revenue increase (5% in
constant currency) was the strongest recorded since the first quarter of
2012. IBM spoke of a very good software pipeline, and referenced good
growth in some important niches like branded middleware (up 10%) and
business analytics (11%).
To put this data into context, here is a graph (sourced from company
accounts) of the segmental revenue share and normalized pre-tax income
share.
Clearly, software is its highest-margin business, and its relative
strength in the quarter helped IBM raise gross margins to 49.7% from
48.3% last year.
With the services backlog up 7%, and higher-margin software returning
to growth in Q2, why aren’t these results as hot as they look?
Four reasons it's still tough out there
First, although software returned to growth in Q2, this was partly due to the weakness in the previous quarter. In fact, growth in the first half
was only 1.9%, which compares unfavorably to 2.6% and 11.5% in the two
previous years. Indeed, a glance at the first chart above demonstrates
that IBM is starting to lap some weaker quarters in 2012.
Second, going back to what IBM said last time around,
$400 million in software and mainframe deals were rolling in to Q2
anyway. When asked about these deals on the current conference call,
management stated that less than half closed in Q2, and, more
importantly, rollovers in higher-margin software are actually larger
going into the Q3. This all sounds good, but there is no guarantee that
rollover deals will get closed. In addition, its main rival Oracle(NYSE: ORCL) also reported some weakness in the quarter.
The third reason is that IBM’s forecast for services
revenue growth in Q3 needs to be put into context. Penciling in growth
of 5% and 2% for business services and technology services,
respectively, would give a total services revenue figure for Q3 of
around $14.9 billion. This compares favorably with the $14.4 billion
recorded last year, but rather less so against the $15.3 billion in
2011.
Finally, the macro commentary wasn’t great. America’s revenues
disappointingly declined 3%. However, the real surprise was within its
growth markets. Revenues in Brazil, India, Russia, and China, were flat
(up 1% in constant currency). In common with Oracle, IBM cited specific
weakness in Russia and China, and it expressed a cautious outlook for
its growth markets for the second half.
Key takeaways for the industry
While the tech market remains weak in 2013, there are pockets of
strength. IBM stated that its cloud revenues were up 70%; Oracle also
reported cloud-based strength. This shows a clear shift in corporate IT
spending towards the cloud and away from legacy on-license/on-premise
software.
Furthermore, the relative strength in IBM's middleware and business
analytics numbers suggests that middleware and data analytics company TIBCO Software(NASDAQ: TIBX) and interactions management provider NICE Systems(NASDAQ: NICE) could do well.
TIBCO finally seems to be sorting out its problems with its sales
force in North America. In addition, its increased focus on big data
analytics solutions, and offering its customers its service both
on-premise and via the cloud, is in line with trends in IT spending. Corporations
may be holding back on discretionary IT spending in general, but they
are still keen to invest in niche areas like social media and customer
engagement. Indeed, TIBCO cited specific strength in sectors such as
financial services and retail.
As for NICE, it has a deal with IBM to
integrate the latter’s analytics within its services. Unlike many areas
of tech spending this year, NICE has been reporting earnings that are
in line with expectations. Moreover, it is seeing strength within sales
of its advanced applications, which allow customers to analyze the data
that its systems capture. Again, this is a sign that in a slow global
economy, corporations are willing to spend on analyzing customer
interactions in order to better manage how they sell into their existing
customers.
The bottom line
In conclusion, IBM and Oracle have both reported earnings, and
neither had particularly good news for the IT spending environment.
Conditions appear to be stabilizing, but the broad-based bounceback in
demand hasn’t really happened yet.
With regards to IBM itself, the company’s story is about its ongoing
paring of lower-margin businesses, and how well it manages its shift
toward more software sales. For longer-term investors, I think the stock
will do fine. If it hits the raised adjusted diluted guidance of $16.90
in EPS for 2013, then it will trade on a forward earnings multiple of
11.4 times, as I write. This is attractive enough, but investors need to
be prepared for potential near-term volatility, because tech spending
remains weak.
The last thing the tech market needed right now was a disappointing set of earnings from Oracle (NASDAQ: ORCL),
but unfortunately that is exactly what it got. It would be an
understatement to say that it has been a difficult 2013 so far for the
tech industry and these numbers will do little to assuage many fears.
But what do they mean for Oracle and how do they relate to the rest of
the tech world?
Oracle disappoints, again
Looking back atan analysis of the previous quarter’s earnings
Oracle missed its own guidance and this quarter saw some key numbers
coming in at the low end. For example Oracle had forecast 1-4% overall
revenue growth (they came in at 2% in constant currency), new software
license and cloud subscription growth was forecast to come in with 1-11%
growth (the result was 2% growth). The one ‘bright’ spot was that
hardware systems product growth was forecast to be negative 12-22% and
came in at the high end with a negative 12%.
Clearly the numbers came in towards the bottom of the guidance
ranges. All of which is somewhat disappointing given that many investors
have been hoping for a second quarter (2Q) bounce back. Last time
around Oracle blamed some sales execution issues and the timing of the
sequester. However it calmed investors by describing its pipeline as
being up and, claimed that the issue was really about the timing and
execution of deal closure.
Well it was a different story this time around with sales execution
quoted as improving ‘significantly’ and economic weakness cited in a few
areas like Brazil, China and Australia. Moreover, transaction sizes
were described as being smaller (a sign of economic pressure).
The good news from a geographic perspective was that its US and EMEA
performance were as expected with 4% and 5% new license growth
respectively. The problem was with Asia-Pacific down 7%. This is a
worrying sign for the industry because many technology companies are
relying on Asia for growth.
What the industry is saying
As a bellwether Oracle’s results will be closely watched and those of
us hoping for some sort of confirmation of a return to better days
would have been disappointed. In a sense it is a mere continuation of
what we have been seeing elsewhere. For example, Palo Alto Networks(NYSE: PANW) recently reported results. It missed estimates and guided lower than the market consensus
for the next quarter. Although Palo Alto is in a different area (IT
security), I found its results interesting because other companies in
the sector had previously reported weakness in April. Unfortunately Palo
Alto came out and confirmed that conditions in May were only ‘in line’
with the reduced expectations created by a weak April. Another indication of weakness and it appears to be linear.
One interesting aspect of Palo Alto is that its telco service
provider revenues do not make up a significant part of its revenues.
This is in contrast with other tech companies like say F5 Networks and Fortinet.
These companies missed estimates and disappointed with guidance. Both
cited weakness in their service provider verticals and this may well
continue into the current quarter. On the other hand Palo Alto's results
are more indicative of the wider tech spending environment and
investors will need to hear some more positive noises from bellwethers
like IBM and Oracle before feeling very confident with Palo Alto.
Moreover Oracle is facing some operational challenges as
it shifts revenues towards cloud-based solutions. It described its SaaS
(software as a service) based revenues as having a $1 billion run rate.
This is fine but to put it into context its full year revenues are
closer to $37 billion. In addition some cloud-based companies like Rackspace Hosting(NYSE: RAX)
have reported some weakness as enterprises still seem keen to use any
excuse to withhold IT spending. In fact in its last quarter it declared
that its revenue per server declined to $1,308 from $1,310 last year.
This is not a good sign for a company supposed to be in a high growth
phase. In Rackspace’s case it was partly due to customers delaying purchases of legacy systems
while they appraised its new OpenStack public cloud offering. Rackspace
also has increasing competition from the likes of Amazon Web Services
(who has been cutting prices) and I take this to be another sign that
conditions have weakened in technology in 2013.
With regards to Oracle’s direct competitors like IBM(NYSE: IBM) and SAP(NYSE: SAP),
these results are obviously not great news and they got marked down in
sympathy. Moreover Larry Ellison was quite candid on his view that SAP’s
Hana database was ‘virtually never’ seen in the market and even
referenced some large German industrial companies that had bought
Oracle’s rival Exadata database machine in order to run SAP’s
applications. He also suggested that Hana could never successfully
compete with Exadata. Frankly there is no love lost between SAP and
Oracle, even when it comes to yachting,
and this sort of comment has been heard before. Moreover I think SAP’s
investors can take some heart from the fact that EMEA (its core market)
was a bit stronger than expected for Oracle.
As for IBM, Oracle’s report was a bit worrying. It pretty much
reported a similar story to Oracle last time around by blaming things
like sales execution, the sequester, the weather and even the change in
the Chinese Government. Will it do the same this time? It’s hard to tell
but IBM didn’t lower its full-year forecast last time around and
announced it would take some workflow rebalancing in Q2. All of which
will put some pressure on it to deliver in the current quarter. As for
the issue with the Chinese Government, did we see signs of this in the
weak results that Oracle just reported?
Where next for Oracle?
The positives in this report were that the transition to new hardware
product systems is going a bit better than expected and the US and
Europe are doing okay. In a sense it is another story of current macro
weakness amidst ongoing change in Oracle’s business as it shifts to
cloud based solutions and new hardware products.
In the last quarter it made sense to pick up some Oracle stock after
disappointing results and I wouldn’t be surprised if the same applies
this time too. The stock trades on an enterprise value to EBITDA
multiple of just 7.4 and generates huge amounts of cash flow that
currently represent over 10% of its enterprise value. On a value basis
the stock looks cheap and I wouldn't be surprised to see Oracle
increasing its returns to shareholders in future. It looks a good long
term hold but be prepared for volatility as the tech spending
environment still looks a little weak this year.
You can either pay sky high evaluations for big data plays or buy a backdoor entry into the sector with a company like Verint Systems(NASDAQ: VRNT).
Companies that already use Verint's customer interaction capture
hardware will increasingly want to buy its data analytics software and
services in order to analyze the captured data. I’m sympathetic to the
argument, and hold its rival and potential partner NICE Systems(NASDAQ: NICE). With that said, recent results from Verint were a mixed bag, and the stock looks fairly valued for now.
Verint reports mixed data
Verint’s first quarter numbers were pretty much in line with expectations, but as I wrote about the last results,
investors would have been justified in expecting a bit more from the
company. Its management was upbeat last time but, like a lot of
technology companies, this quarter's results were mixed.
In short, Europe, the Middle East and Africa proved to be a headwind,
while the Asia-Pacific region’s growth was strong enough to counter it.
European growth is now expected to be near flat for the full year
versus previous expectations of small growth. This affected its core
Enterprise Intelligence business and meant that it only grew by 1.2% in
the quarter as opposed to the total revenue growth of 2.6%.
In order to see how Verint generates its revenues, I’ve broken out 2013 segmental revenues below.
In geographic terms, the first quarter saw 54.6% of its $205 million
in revenues coming from the Americas, with Europe, the Middle East and
Africa contributing 20%, as opposed to 25% for the first quarter last
year, and Asia-Pacific with 25.4%. While the Europe, Middle East and
Africa decline of $9 million was unwelcome it wasn’t enough to put a
dampener on the overall results.
Communications intelligence is an area where Verint is stronger than
NICE, and it demonstrated an impressive 7.2% revenue growth. The
government vertical is large for Verint -- traditionally around 25% of
revenues -- and there were some concerns that it would be affected by
the sequester. Clearly these worries turned out to be misguided, and
Verint’s international exposure certainly helped. In addition, this type
of intelligence gathering and surveillance activity is not going away
anytime soon.
However, the biggest positive surprise was probably that the video
intelligence segment revenues only fell by 1.7% after declining 13.4%
over the last year. There was some discussion in the conference call of
increased interest following the tragic events in Boston and such events
emphasize the need for expenditure on these types of solutions.
Elsewhere in the segment a $4 million order came in from a big box
retailer in order to help it reduce shrinkage.
Long term growth drivers
Putting these elements together demonstrates that the key drivers of
Verint’s future growth are still in place. As argued in the conference
call, customers likely want to buy solutions from a single vendor and as
Verint already has a substantial installed base with its data capture
solutions, it can expect future growth. In addition it has a number of
secular drivers in its favor. For example, even in a slow economic
environment, financial institutions generate growth by investing in
analyzing existing customer interactions. Similarly reducing fraud and
money laundering will always be a part of a financial firm or contact
center’s operations.
Indeed, a quick look at NICE Systems' recent results
revealed these positive underlying trends. Similar to Verint it kept
full year guidance intact. NICE is seeing an increased willingness among
its customers to sign bigger deals and integrate its analytics
solutions with its product sales. NICE is well positioned to do this,
particularly to its string verticals like financials and contact
centers, because of its partnership with IBM(NYSE: IBM).
Back in October, NICE announced that it would be integrating IBM’s big
data analytics software within its solutions. It’s a mutually beneficial
solution because IBM will get entry into NICE’s installed base while
also giving NICE added functionality with which it can add value to
customers.
The interesting thing about IBM’s results
is that they somewhat presaged weaker conditions for IT enterprise
spending and set the tone for a disappointing IT earnings season. The
fact that NICE and Verint reported results that were pretty much in line
and kept full year growth expectations is therefore somewhat of a net
positive.
Where next for Verint?
Full year guidance is for 6%-7% growth and earnings of around
$2.75 and free cash flow generation of around $100 million. At the
current price this makes for a forward PE of around 12.8 and a free cash
flow yield of around 5.3%. All of which is pretty fair value for a
company forecast to generate single digit earnings growth over the next
couple of years. I suspect the stock is also being
supported on the back of speculation over a possible acquisition by
NICE. It’s worth monitoring but hard to make a case that it is great
value right now despite the positive long term prospects.
It’s been an unusual earnings season so far. The market has kept
moving higher even though many tech companies have warned. This can
appear counter intuitive because tech is usually seen as a cyclical part
of the economy. In other words, if tech is slowing down, then the
economy will do too. Surely, if tech companies are warning, the market
should be pricing in a slowing of growth rather than moving up in
anticipation of stronger growth?
Pricing in a recovery?
One explanation for this is that the first quarter saw a weakness in
technology spending which should be rectified in coming quarters.
Indeed, I have suggested some reasons why this might be the case in an article linked here.
If this argument is correct, then buying after the tech companies warn
should be a good tactic. The chances are that expectations will have
been lowered and the falls would have created some decent entry points.
In order to avoid the dangers of relying on anecdotal evidence and
hearsay, I decided to take a bit of a methodological approach and see if
the data supported the idea.
The companies in this graph are those that warned or gave
disappointing results in the current earnings season. They were garnered
from the NYSE Arca Tech 100 Index. I have excluded biotech and focused
on the IT hardware and software companies.
The blue lines are the stock’s performance since the day after the
warning and the green lines are how they have performed against the
S&P 500 since they warned. The data is current till April 20.
I think the evidence is pretty clear. Tech companies have tended to
outperform the market since they warned. I appreciate that part of this
effect might have been investors looking to buy stocks that looked
‘cheap’ in a rising market, but on the other hand, the evidence above is
pretty broad based.
If I am right about this, then investors should start to look at potential tech company warnings as buying opportunities.
Who said what?
It’s time to look at a few of these companies to see what the
specific issues were. This is useful because it helps us understand what
is causing this effect.
I’m going to start with Oracle and International Business Machines Oracle blamed its disappointing earnings on sales execution failures.
This is partly a consequence of adding significant numbers of new
salesmen and the inevitable disruption that this causes. In addition,
its management argued that the pipeline was still in place, it was just
that deals were not completed at the rate that they had expected. Oracle
expects these issues to be ironed out ‘quick’ and argued that it wasn’t
losing any market share.
Thinking longer term, Oracle does have question marks
over some hardware product transitions and dealing with the affects that
the shift to the cloud (Oracle still has substantive legacy software
sales) will have on its revenue.
IBM delivered a very rare miss and I took it as an opportunity to buy some more.
In a familiar refrain, it blamed sales execution but also managed to
discuss the sequester, the change of Chinese leadership, the timing of
Easter, and even the weather.
The good news is that -- just as Oracle did -- it argued that the
pipeline hadn’t been reduced and deals weren’t lost to competition. It’s
just that its sales guys just had a hard time closing deals in the
quarter. The response was to do as IBM does and make some operational
adjustments (workforce re-balancing) in the next quarter.
Citrix Systems
also saw revenue and earnings come in lighter than expected. In
addition, its Q2 earnings guidance was significantly below estimates. In
actuality, it was a mixed quarter for Citrix. Its Netscaler product (an application delivery controller that competes with F5 Networks)
saw good growth, but its core virtualization growth was disappointing.
The latter has higher margins, so the net effect was to reduce
expectations for overall margin growth in future.
It’s always worrying to see a company’s core activity slowing, but
Citrix had a feasible excuse. It launched its XenMobile mobility
solution in Q1 and it is entirely understandable if some of its
customers may have decided to hold off purchases while they assess
buying the new product. Again, Citrix outlined that its full year plans
were ‘on-track’.
The bottom line
In conclusion, all three companies saw what looks like some temporary
weakening caused by hesitation among customers rather than a reduction
in overall spending plans. Although they all had their own reasons for
disappointing, there was a common theme. All three saw their pipelines
intact but customers exhibiting caution in their spending decisions. If
this dissipates in future quarters (and it may do so after the media
stops talking about the sequester) then buying these names, and others
within technology, will prove to be a wise choice.
Date network hardware manufacturer Emulex beat estimates, but in a recurring theme in this reporting season, Emulex gave guidance which was below the top end of analyst forecasts. For the last few quarters investors have got used to companies beating and estimates may well be above potential outcomes. Nonetheless, these results are good from Emulex.
Emulex reported Q2 results of
Revenues of $114m vs. market forecast of $113.4m
EPS of 15cents vs. market forecast of 13cents
For Q3 Emulex guided towards
Revenues of $108-112m vs. market forecast of $110.5m
EPS of 8-11cents vs. market forecast of 11cents
The results were disappointing in the context of the excellent numbers that IBM (their largest single customer) gave last week. Moreover, rival company QLogic upgraded guidance recently and there were a lot of hopes that Emulex would too.
Listening to the conference call, the management was upbeat about prospects and in particular, the upgrade cycle towards 10GB Ethernet based net revenues.Emulex top brass talked of ‘meaningful’ growth in the June quarter (Q4 fiscal) which was later referred to as ‘high single digit’ revenue growth. This is traditionally a weak quarter for them.
Host Server Products (HSP) makes up the bulk of revenues (81%) and this is where the growth is coming from. Embedded Server Products (ESP) is still in decline but they are seen as providing easy comparatives going forward. Emulex still feels that HSP will be the growth driver going forward. The senior management discussed 18-20% calendar year growth but it is hard to see them achieving that. If I assume that 8% is the ‘high single digit’ growth for June and Mar is predicted at $110m (midpoint) this gives $110+(103.1*1.08)=221m and 500m would be the target. This means the second calendar half has to do around 279m.
This looks to be a rather decent ‘ask’. Nonetheless, these numbers don’t suggest any slowdown in data center or internet hardware spending. Instead, it looks like analyst forecasts have been too exuberant.
The main reasons appear to be that its customers are reluctant to build up inventory due to uncertain consumer demand. Indeed, only a day later Taiwan Semiconductor (NYSE: TSM ) said its fourth quarter revenue could fall by 11%, due to "softer demand for certain high-end smartphones and inventory correction." This is a worrying comment given that the fourth quarter is traditionally the strongest for the industry.
