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Market Update

No Way to Sugarcoat IBM's Weakness

Our long-run view of the tech giant is still intact despite disappointing third-quarter results, but a number of headwinds are impeding IBM's growth, says Morningstar's Grady Burkett.

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 International Business Machines' (IBM) third-quarter results were disappointing, as the firm continues to struggle to reinvigorate revenue growth in key product categories. We expect to reduce our near-term revenue forecasts, though not materially enough to change our fair value estimate. We still believe IBM can deliver 2% annualized revenue growth and 3% annualized operating income growth, on average, during the next several years. We also maintain our wide moat rating. IBM is likely to trade firmly in undervalued territory Thursday, providing patient investors a relatively attractive entry point for a core technology equity holding.

Although we maintain our long-run view, there's no way to sugarcoat IBM's recent weak performance or the intermediate-term challenges still ahead. Total revenue declined 4% year over year to $23.7 billion, and while non-GAAP earnings per share grew 10% from the year-ago quarter to $3.99, gross profit and operating income posted mid-single-digit declines. In other words, IBM's EPS growth was driven purely by nonoperating items. A number of headwinds are impeding IBM's growth. U.S. federal budget pressures, weak demand out of China, hardware commodification, and increasing competition among enterprise software vendors will continue to be issues in the fourth quarter and into 2014. 

Free cash flow, excluding finance receivables, came in at $2.2 billion, bringing IBM's year-to-date free cash generation to $6.6 billion, a decline of $2 billion from the first nine months of 2012. So far this year, IBM has spent $2.6 billion on acquisitions, $3.0 billion on dividends, and $8.1 billion on share repurchases. The firm's net cash position, including finance receivables, now stands at $2.5 billion, the lowest level of the past three years. IBM's free cash generation is seasonally strong in the fourth quarter, and we would not be surprised to see management be aggressive in repurchasing shares throughout the remainder of 2013. 

Given the firm's inability to generate meaningful operating income growth in the current environment, management will probably rely more heavily on share repurchases to achieve its 2015 non-GAAP earnings target of $20 per share.

At the segment level, software results were the most troubling, in our view. IBM's overall software revenue grew just 1% year over year to $5.8 billion, with its strategic key branded middleware portfolio delivering just 3% growth. We were particularly disappointed to see almost no growth out of the information management or WebSphere product categories, which include middleware, database and data analytics software. These software offerings are important components of IBM's wide economic moat, as they are incredibly sticky product suites that generate high-margin recurring revenue and allow IBM to deepen its relationships with customers. IBM's market share in these software segments has been fairly stable during the past few years, and we do not believe the firm is being displaced in existing accounts.

Demand across the IT industry has been fairly weak this year, particularly for large upfront software purchases, and we believe it is still too early to change our long-run view of IBM's software business. Still, we are moderately less confident in our 2014-17 growth expectation of roughly 5% annualized for IBM's software portfolio, especially given the longer-term threats from the continued push toward cloud-based software applications and increasing competitive pressures from Microsoft and Oracle. Our fair value estimate would fall about 9% if we were to adjust our current growth forecast down to 1% annualized, basically extrapolating third-quarter results. At nearly 50% of pretax income, software is a key driver of IBM's valuation and source of competitive advantage.

Hardware was once again extremely weak, falling 17% from the year-ago quarter to $3.2 billion. Mainframe revenue posted 6% year-over-year growth, as IBM continues to benefit from its refreshed System z portfolio. The firm will lap difficult comparisons again next quarter, and investors should be prepared for a sharp decline in System z revenue in the fourth quarter. The rest of IBM's hardware portfolio delivered horrendous results, with proprietary power servers, x86-based servers, and storage arrays declining 38%, 18%, and 11%, respectively. While IBM is not well positioned for growth in any of these three areas, we are concerned that its weak results may point to disappointing product revenue from other enterprise hardware vendors, such as Cisco and Hewlett-Packard. This quarter marks the third straight quarter of pretax losses from IBM's hardware segment, despite benefiting from the mainframe refresh.

IBM views the majority of its hardware assets, particularly mainframes, as strategic and it believes it can differentiate its hardware offerings and compete over the long term. With the possible exception of the x86 server business, we doubt the firm will make significant changes to its hardware strategy in the near term. Still, the current hardware revenue base is clearly too small to support this segment's existing cost structure, and we doubt senior management, or investors, will accept quarter after quarter of operating losses out of this business. This will be an important dynamic to watch throughout 2014 as the firm balances investments in its on-premise hardware business with its evolving cloud infrastructure portfolio, which appears to us to be coalescing around SoftLayer.

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Grady Burkett does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.