IBM Avoids Facing Reality, Shareholders Need To Act Now

Investment Thesis

IBM Corp. (NYSE:IBM) delivered unimpressive Q1 2018 results, and its shares sold off slightly. While I understand that the vast majority of the readers of this article are in “IBM for the long run” and “happy to collect its dividend”, I continue to argue that this is fallacious thinking. Investing in IBM for its dividend yield of 4% but then seeing its shares fall over time more than erases any collection from its dividend. I remain unwavering in my belief that there are much better opportunities elsewhere.

Recent Results

In my previous article earlier this month, I wrote:

what the market wants [from IBM], at the end of the day, is growth; solid, predictable and sustainable revenue growth. IBM cannot offer investors what they ultimately seek.

Taking The Tough Route

If we exclude IBM’s Global Financing debt, the company has a remarkably solid financial position; in fact, it is very close to being debt-free. Also, given that IBM clearly generates strong free cash flow, it has plenty of room to maneuver. One potential avenue for the company would be to divest its underperforming businesses, bring in some extra cash and use this cash to reinvest back into its operations, such as its “Strategic Imperatives”, which are performing well.

Moreover, IBM’s cloud business is one where it is clearly doing well. I have no arguments here. I have actually reported on the cloud sector’s prospects several times in the past weeks here on Seeking Alpha – discussing how the competition for cloud market share is intense, but on the other hand, how the opportunity is far from saturated and that the whole sector is benefiting from remarkably strong tailwinds (this article discusses the opportunity and is still free at the time of writing).

But right here is the problem. Management’s insider ownership is roughly 0.05%. So, it is not even half of one percent, but ten times less than that – which, when compared with executive compensation, there appears to be quite a mismatch. For example, CEO Rometty’s “non-equity incentive plan” compensation (meaning cash incentive) continues to tick up over time – it presently stands above $5 million. Again, this is not her $1.6 million salary, nor is this her $10 million stock compensation award; it is simply a cash incentive to deliver the poor results which IBM’s shareholders have had to endure in the past 5 years. Thus, the company’s problem is not a lack of opportunity, nope. IBM’s problem comes from management’s lack of desire to stop controlling such an “empire” of businesses with which it is able to command the type of compensation packages discussed above. Because if IBM were to become a much smaller enterprise, CEO Rometty and her team would most likely have smaller compensation packages proportionate to other smaller public companies.

More on IBM’s Cloud Prospects

Whereas others in the financial media have highlighted that the company’s cloud performance was subpar, I am not so short-term oriented. IBM’s cloud revenue over last 12 months was still up 20%, which is truly the crown jewel in its portfolio.

Although, having said that, the company’s cloud revenue only generated $4.2 billion out of its consolidated $19 billion revenue (or approximately 22% of consolidated revenue). So, even if the cloud is growing at solid double digits, it is still too small to have a meaningful impact on IBM’s overall results, which ended flat (adj. for FX) in Q1 2018 versus the same period a year ago. Thus, with the company’s rhetoric aside and solely focusing on its consolidated results, we can see that IBM’s financials do not support its current valuation.

Valuation

In the above table are shown the facts – that although IBM’s present valuation is indeed a nudge below its 5-year average, it is still a tough investment to make and hope to come out winning by investing at the current price of $140 billion market cap.

One could argue that when compared with its peers, such as Microsoft (NASDAQ:MSFT), IBM presently offers investors a tremendous opportunity to profit. However, I would have to disagree, because in Microsoft’s case, it is highly profitable, while at the same time it has been able to show that it has reignited its growth engine once again. Further, Microsoft’s ambition to gain cloud market share from the competition has seen Azure deliver several quarters of +85% year-over-year growth, which is quite astonishing.

On the other hand, IBM’s cloud has started to move in the correct direction, but the company’s cloud business remains too small relative to its consolidated operations. Overall, for now, it remains tough for IBM to impress the Street.

Takeaway

I continue to highlight that until IBM is willing to ask those difficult questions, such as which businesses are no longer delivering a high enough return on investment, and divesting of its underperforming businesses, the company will not be rewarded with a higher multiple.

It is the ability of business leaders facing difficult times to make tough choices that lead businesses back to growth mode and reward their investors. At the moment, IBM is not being led by this sort of management.

Disclaimer: Please do your own due diligence to reach your own conclusions.

Note: The only favor I ask is that you click the “Follow” button, so I can grow my Seeking Alpha friendships and our Deep Value network. Please excuse any grammatical errors.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.