Valuentum Exclusive Analysis for the Discerning Investor

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Image Source: International Business Machines Corporation – 2019 Annual Report

By Callum Turcan

On July 20, International Business Machines Corporation (IBM) reported second quarter 2020 earnings that beat both consensus top- and bottom-line estimates. Most of the market’s excitement centered on IBM’s ‘Cloud & Cognitive Software’ segment posting year-over-year revenue growth of ~3% in the second quarter while its company-wide GAAP revenue declined by ~5% year-over-year, though initial gains in IBM’s share price faded away during regular trading hours on July 21. In the earnings press release, IBM noted its “total cloud revenue” grew by 30% year-over-year last quarter. Shares of IBM are trading near their fair value estimate of $129 as of this writing, indicating that shares of IBM appear fairly valued.

Operational Update

During the firm’s latest quarterly conference call, management touted IBM’s focus on hybrid cloud offerings (generally speaking, combining IBM’s cloud computing offerings with hardware located on-site). Though the transition to cloud computing as the backbone of enterprise-level IT operations has been going on for some time, IBM’s management team noted during the earnings call that (emphasis added):

“…IBM is focused on helping our clients in the two major transformational journeys they are on: hybrid cloud as well as data and AI. Hybrid cloud is the dominant force driving change in our industry, but it’s far from universal adoption. Only 20% of the workloads have moved to the cloud. The other 80% are mission-critical workloads that are far more difficult to move. There is a massive opportunity in front of us to capture these workloads. When I say hybrid cloud, I am talking about an interoperable IT environment across on-premise, private, and publicly operated cloud environments, in most cases from multiple vendors.”

The company plans to continue investing heavily in the hybrid cloud space. However, the ongoing coronavirus (‘COVID-19’) pandemic has weakened demand from IBM’s smaller enterprise customers according to management. Additionally, IBM noted many of its customers delayed IT projects and deferred purchases, likely to conserve cash during the pandemic. That played a big role in reducing IBM’s revenues last quarter, and COVID-19-related headwinds will likely continue going forward.

Financial Update

At the end of June 2020, IBM had $14.1 billion in cash, cash equivalents, and marketable securities on hand (not including IBM’s ~$0.15 billion restricted cash position) versus $64.7 billion in total debt (including $9.3 billion in short-term debt). Though its liquidity position is strong, and its debt maturity schedule is manageable, IBM’s large net debt position weighs negatively on its dividend coverage on a forward-looking basis. IBM acquired Red Hat for ~$34 billion (total equity value) in 2019 through an all-cash deal, which greatly increased IBM’s net debt load. Revenue at IBM’s Red Hat subsidiary was up 17% year-over-year last quarter.

IBM generated $3.1 billion in free cash flow during the second quarter and spent $1.5 billion covering its dividend obligations. We like IBM’s cash flow profile as roughly 60% of its revenues are recurring according to management commentary. IBM did not repurchase a meaningful amount of its stock last quarter as it halted its share repurchasing program after acquiring Red Hat.

We give IBM a “GOOD” Dividend Safety rating due to its 1.0 Dividend Cushion ratio, a product of its strong cash flow profile offsetting its large net debt load. During the second quarter, IBM did a solid job controlling its core operating expenses (removing other operating income/expenses from this picture, which swung from an operating gain in the same period a year-ago to an operating loss last quarter) which further supports its cash flow outlook. Last quarter, IBM’s combined SG&A and RD&E expenses were down marginally year-over-year.

Though IBM’s GAAP operating income and margin came under stress last quarter (due to its shrinking revenues and its other operating income swinging to an operating loss), the firm was able to grow its GAAP gross margin by 100 basis points year-over-year (and its non-GAAP adjusted gross margin was up 160 basis points) due to operational efficiencies and its growing cloud computing segment. We appreciate IBM’s ability to realize gross margin gains, though we caution that its operating margin will likely remain pressured in the near term.

Management did not provide full-year guidance for 2020 due to COVID-19 making predicting IBM’s future financial and operational performance no easy task. IBM does not want to make predictions in such a volatile climate, and management noted the firm’s performance would be dependent in part of the state of the broader economy as IBM waits for its customers to start spending more and investing more aggressively in their IT needs.

Concluding Thoughts

IBM bet big that by acquiring Red Hat that it could speed up its transition to becoming a major provider of cloud computing offerings and hybrid cloud solutions. The company showed some promise on that front during its latest earnings report, though the pandemic got in the way of its performance. In the second quarter of 2020, IBM’s cloud revenue represented a little over a third of its total revenue streams. Management mentioned that IBM had “a compelling set of offerings and a strong pipeline across software, services, and systems” as the company enters the second half of 2020. We will have more to say as we get deeper into 2020.

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Callum Turcan does not own shares in any of the securities mentioned above. Apple Inc (AAPL), Cisco Systems Inc (CSCO), Intel Corporation (INTC), and Microsoft Corporation (MSFT) are all included in both Valuentum’s simulated Best Ideas Newsletter and Dividend Growth Newsletter portfolios. Oracle Corporation is included in Valuentum’s simulated Dividend Growth Newsletter portfolio. Both the simulated Best Ideas Newsletter and Dividend Growth Newsletter portfolios include a SPDR S&P 500 ETF Trust (SPY) put option holding with a $295 per share strike price that expire on August 21, 2020. Some of the other companies written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.