IBM: Mixed Bag Of High Growth Engines And Capital Inefficiency (NYSE:IBM)

With a solid and long history of technological innovation, it's easy to see why one should invest in IBM (NYSE:IBM ). The company, indeed, has strong growth drivers from a lot of cutting-edge technologies crucial to future innovation. However, the drag on the company mostly comes from its capital inefficiency, causing margins to trend lower in recent quarters, and its stock prices to go sideways. It is essential that the company take decisive actions to improve them without losing focus on its tech advantages. Until we see more progress on that front, we recommend a hold at the moment.

IBM was founded in 1911 as a holding company of manufacturers of record-keeping and measuring systems. The company was renamed “International Business Machines” in 1924 and is one of the world's oldest and largest technology companies. Its current products include computer hardware/software, machine automation, robotics, artificial intelligence, cloud computing, and quantum computing. Its reportable segments are Software, Consulting, Infrastructure, and Financing. BOPP Bag

IBM: Mixed Bag Of High Growth Engines And Capital Inefficiency (NYSE:IBM) | Seeking Alpha

IBM is an all-weather technology company with a comprehensive reach in all important aspects of technology today. But as the company described, its current portfolio is “built around hybrid cloud and artificial intelligence, the two most transformational technologies of our time”. And it prides itself on its unique ability to integrate technology and business expertise for its clients and partners. Indeed, IBM makes technical innovations and finds business applications for them.

IBM's revenue reached its highest level post last recession, but has gradually fallen since. It had a steep decline in Q4 2020, but quickly rebounded from it and back to its average post-pandemic. That quarter of decline was primarily due to the pandemic, so it's an outlier.

IBM Quarterly Revenue vs Gross Profit (Calculated and Charted by Waterside Insight with data from company)

From its revenue, we break it down into segments to see which has the fastest growth. Before 2020, the company's segment reporting was different than it is now, which makes the results not exactly comparable. So we only show the segment breakdown since 2020. As it shows, the fastest-growing segments are software and consulting. Software grew on average 6% YoY while consulting grew on average 8% YoY. Its other segments are flat to declining in growth.

IBM Revenue by Segment (Charted by Waterside Insight with data from company)

And if we zoom in further, within the hybrid cloud's revenue, the software and consulting segments' growth is even faster than in general. The hybrid consulting grew 34% YoY in 2021 and then 15% in 2022, while the hybrid software grew 29% YoY in 2021 and then 11% in 2022.

IBM Hybrid Cloud Revenue by Segment (Charted by Waterside Insight with data from company)

These breakdowns make it very clear why the company transitioned from hardware to software with a focus on hybrid cloud and AI - they could provide double-digit growth in the near term future.

For IBM, stable growth is one of its strengths. And it shows in its cash flow. Its free cash flow, although it came down from its higher level maintained for almost a decade, is still within its historical norm. And its net cash flow, after its large payment to settle debt and acquisition spending on Red Hat in 2019, has also stayed within its normal range.

IBM Quarterly Cash Flow (Calculated and Charted by Waterside Insight with data from company)

And currently, the company has the absolute lowest inventory level in its history. It is both due to effective management and a strong sales pace.

IBM Inventory (Calculated and Charted by Waterside Insight with data from company)

IBM has a strong track record of rewarding shareholders. Its dividend payout has been increasing since 2000, and is currently with a forward dividend yield of 5.23%.

IBM Dividend History (Calculated and Charted by Waterside Insight with data from company)

While the company's overall financials haven't improved significantly, they are not deteriorating either. We see burgeoning growth momentum from IBM's strategic focus. The numbers also show that the acquisition of Red Hat two years ago has laid a foundation for long-term growth in the hybrid cloud for the company.

IBM still has weaknesses on several fronts. The company's gross profit remains elevated, but all other essential margins have declined. In particular, its net margin on a TTM basis is inching close to zero. And its operating margin has only bounced back from 2020's low point.

IBM Margin Analysis (Calculated and Charted by Waterside Insight with data from company)

IBM's operating cash flow has had one of its most significant slides since 2021. This is on top of its gradual downtrend since 2012. Now its operating cash flow level is back to its 90's of last century. Although the company has been cutting back capital expenditure, perhaps mostly related to the hardware business segment, the decline in operating cash flow still makes it too large in total to compensate for it.

IBM Capex vs Operating Cash Flow (Calculated and Charted by Waterside Insight with data from company)

As one of the world's largest companies, IBM needs to rein in its cost and expense better. The company spent the past 8 years registering cost of revenue plus operating expenses in the average of 85% of revenue. With this ratio, it is hard not to have its margins trend lower at the same time. But looking back at its history, the cost and expenses ratio over revenue has always been high, with the lowest being 70% and could get as high as 95%. Does it matter now if it cut it down or not? We think so because it has higher revenue growth before 2012, and a lower debt level.

IBM Cost and Expenses Analysis (Calculated and Charted by Waterside Insight with data from company)

IBM currently has one of its highest debt-to-EBITDA ratio at 7.53x. IBM has long maintained a low debt ratio concerning EBITDA, but since its acquisition in 2019, its debt load has been growing fast. In particular, it made 15 acquisitions in 2022. Although its average debt cost is only 5-6% per year, it is not a crippling burden in the short term or medium term, investors should still keep an eye on how the company is managing it and how it might affect its dividend payout.

With such a high level of debt utilization, IBM's return ratios have not been matching up. All of its major return ratios are on a downward trend without seeing a turnaround yet. Its return on equity ratio in 2022 is only 8%. We think high costs and expenses are one of the root causes. Another main reason is the small acquisitions it has been making over the years. The company, on average, made about 10 small acquisitions per year in the past two years since acquiring Red Hat. Perhaps not all the acquisitions are well-oiled into synergy for the company as a whole. And when they accumulate, the inefficiency would be hard to cut down as they are embedded in different individual units or departments. For example, when consulting and building McDonald's automatic order-taking system last year, the company went straight to buy McDonald's whole legacy system to "accelerate the development" of the project. We are scratching our heads a little on this. In other words, IBM does not lack growth engines. What is lacking is efficiency in capital utilization.

IBM Return Metrics (Calculated and Charted by Waterside Insight with data from company)

IBM Financial Overview (Calculated and Charted by Waterside Insight with data from company)

We take account of all our analysis above and use our proprietary models to project ten years ahead to evaluate IBM's fair prices. In our bullish case, IBM's cash flow growth has some near-term decline, but the company is able to continue cutting costs and revive its operating cash flow, with strong growth afterward; it is priced at $201.50. In our bearish case, IBM has a cash flow decline in 2023 and 2024, with a rebound followed by somewhat muted growth; it was priced at $139.65. In our base case, the company's '23 and '24 cash flow decline is in with a strong rebound afterward, but lowering its costs and boosting capital efficiency are longer-term problems that it still has some struggles with; it was priced at $172.52. Overall, the market is a bit too pessimistic than our fair valuation.

IBM Fair Valuation (Calculated and Charted by Waterside Insight with data from company)

IBM has a great history of being part of a lot of critical technological innovations that led to our modern life. Its strong reputation in technological capacity makes its business focus transition from hardware to software and consulting smoothly. With it at the cutting edge of technological breakthroughs, including AI, robotics, hybrid cloud, and quantum computing, IBM's long-term growth drivers are strong. But due to the recent years' large acquisitions and expansion, its capital efficiency has continued to decline. We believe the management has its work cut out in this regard, and improving this won't be easy or quick. Due to some of the declining trends that have persisted for a while, its stock prices haven't made significant improvements either. We are optimistic but also realistic about the company's growth trajectory from here on. It's easy to see IBM stock is currently undervalued, but it's for valid reasons. We recommend a hold and looking for more solid improvements before participating.

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Animal Feed Bag Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.

IBM: Mixed Bag Of High Growth Engines And Capital Inefficiency (NYSE:IBM) | Seeking Alpha