IBM's weak results hide its growth potential

Accounting rules and one-time items dragged down the tech giant's third-quarter numbers, but its long-term investment thesis remains attractive.

| More on:
a woman

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.

At first glance, International Business Machines' (NYSE: IBM) third-quarter results looked disappointing, featuring declining revenue and shrinking earnings per share. But as has often been the case with the giant tech company, one-time items again muddied the picture. And based on conditions in its underlying business, the stock may constitute an interesting investment opportunity.

Weak results

IBM's revenue declined by 3.9% year over year to $18.0 billion during the third quarter. But excluding the effects of foreign currency and divestitures, the top line fell only 0.6%. Still, the company's fifth consecutive quarter of revenue declines should worry investors, especially since this was the first time that figure included $371 million from IBM's $34 billion Red Hat acquisition. 

Also, IBM's GAAP operating margin dropped from 16.0% to 8.4%. And despite an effective tax rate of negative 9.9%, its GAAP net income decreased 38% year over year, from $2.69 billion to $1.67 billion. 

During the earnings call, management highlighted the point that they had cut the company's $73 billion debt load by $6.7 billion to $66.3 billion. But that success isn't as significant as management suggested, due to the decrease in cash and equivalents. Excluding the impact of the Red Hat acquisition on IBM's cash balance, its net debt decreased by only $3.85 billion compared to the previous quarter.

Temporary issues

Short-term challenges explain the quarter's negative results.

Revenue from IBM's systems segment, which includes servers and storage systems, dropped 14.7%. But that performance shouldn't surprise investors. The third quarter marked the end of an IBM product cycle -- the company started shipping its new mainframe z15 server during the last week of September. Thus, revenue from the systems segment should increase over the next several quarters.

The decline in IBM's global technology services -- GTS -- was more surprising. GTS consists of managed and outsourcing services, cloud-delivered services, and maintenance activities. Since this segment provided 38.8% of the company's total revenue at a gross profit margin of 35.8% during the quarter, its performance impacted IBM in a meaningful way.

Management pinned the 5.3% decline in GTS revenue on a lack of extra business beyond that which the segment booked prior to the quarter. But that should turn around since signings -- a leading indicator of revenue -- increased by 20% during the third quarter.

Growth on the horizon

Beyond the challenging short-term results, there are credible scenarios for IBM to deliver revenue growth.

Under GAAP rules, Red Hat contributed $371 million to IBM's revenue during this recent quarter, but had it remained an independent company, with the same underlying results, it would have reported revenue of $987 million. The difference arises from a rule that requires companies to recognize their acquisitions' deferred revenues at fair value. This has one important consequence: It will lower the amount of revenue IBM will recognize from its Red Hat acquisition over the next few quarters. But it will also give the company favorable comparisons further down the road.

In addition, since Red Hat was purchased, its normalized revenue growth accelerated from percentages in the mid-teens to 20%. IBM is already taking advantage of cross-selling opportunities to propose Red Hat solutions to its large client base. 

And taking into account the new product cycle in IBM's systems segment, management confirmed it is still targeting revenue growth in the mid-single-digit percentages over the medium term -- the same forecast it announced after the Red Hat acquisition.

A simple and attractive investment proposition

With only one quarter left in 2019, IBM's management still forecasts non-GAAP earnings per share and free cash flow to reach $12.80 and $12 billion, respectively, for the year.

At the time of this writing, the market values this tech stock at a forward P/E ratio of 10.2 and at a free-cash-flow multiple of 9.9. Those modest valuation figures indicate the market doesn't expect much growth. Thus, long-term investors should consider IBM as a slow-growth investment at a reasonable price.

This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.

Herve Blandin owns shares of IBM. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has the following options: long January 2020 $200 calls on IBM, short January 2020 $200 puts on IBM, and short January 2020 $155 calls on IBM. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

More on International Stock News

Happy woman on her phone while her electric vehicle charges.
International Stock News

Is Tesla the best EV stock for you?

Tesla stands out as the premier EV maker, but it might not be right for every investor.

Read more »

A woman sits on sofa pondering a question.
International Stock News

After Nvidia's 10-for-1 stock split, is it still a buy?

Nvidia shares saw a bump after their recent split.

Read more »

Investor looking at falling ASX share price on computer screen
International Stock News

Nvidia stock drops 6.5%, dragging artificial intelligence stocks lower

Is the AI bubble bursting?

Read more »

A cool young man walking in a laneway holding a takeaway coffee in one hand and his phone in the other reacts with surprise as he reads the latest news on his mobile phone
International Stock News

Thinking about buying Nvidia stock? Here's why you might already own it

You might not have missed out on Nvidia's gains after all.

Read more »

Man smiling at a laptop because of a rising share price.
International Stock News

Nvidia investors just got some bullish news

The GPU leader has opportunities for robust growth beyond the artificial intelligence market.

Read more »

A beautiful ocean vista is shown with a woman whose back is to the camera holding her arms up in triumph as she stands at the top of a rock feeling thrilled that ASX 200 shares are reaching multi-year high prices today
International Stock News

Is Nvidia stock going to $200 in the wake of its 10-for-1 stock split?

Wall Street analysts are boosting their price targets in the wake of Nvidia's high-profile stock split.

Read more »

A boy with a gold crown stands stoically looking straight ahead.
International Stock News

Can anyone topple Nvidia as the king of artificial intelligence investments?

There are many comparisons, but nearly all fall short.

Read more »

A woman stands triumphant with arms outstretched as she overlooks a city at sunset.
International Stock News

Nvidia shares reach world's most valuable milestone. Where to now?

Nvidia beats out Apple and Microsoft to be number one in the world.

Read more »