- Q3 results are expected to be hit by USD strength and EM exposure
- IBM is in the process of reinventing itself for the age of robotics
- Viewed through a long-term lens, value would appear to exist
Savvy IBM is retooling for the future. Photo: iStock
By Peter Garnry
IBM is expected to report weak Q3 earnings tonight after the US market close. The shares have significantly underperformed the S&P 500 over the past year and disappointed shareholders, but the current valuation levels may finally have reached an interesting entry point for long-term investors.
Macro headwinds to overshadow Q3 earnings
Analysts expect EPS to decline by 10.2% y/y and revenue to decline 12.4% y/y as IBM is being hurt by stronger USD and its high exposure to emerging markets. In addition, the IT legacy business is also suffering as IBM diverts resources away from this segment and into its higher value-added products and services such as cloud, analytics and engagement which it calls the Strategic Imperatives segment.
IBM monthly share price since 2005
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The increasing headwinds and negative growth in its legacy businesses have pushed the share price significantly lower since the peak in 2013. Over the past year the shares have declined 8.6% compared to S&P 500 which rose 6.8%
With the USD strength fading as the lower USD rates regime is extended by Federal Open Market Committee and everything points towards a longer period before the Fed Funds Rate reaches its neutral policy target, IBM will see macro improvements on its results. As a result we expect the underperformance to reach a turning point and we believe the current share price level represents a good entry point for long-term investors.
Machines will dominate the future
To understand why IBM is attractive for long-term investors we have to look to the future. IBM is entering a new period in which it is transforming itself into the future of predictive analytics and cloud-based software services.
IBM is allocating increasingly more resources towards its Strategic Imperatives segment though this is unfortunately not yet separated into its own accounting segment. In Q2 the SI segment grew more than 20% y/y YTD and more than 30% adjusting for currency and the divested System x business. The growth rate in its total cloud business is 50% y/y in Q2 and the mobile analytics business quadrupled. Overall, these are fantastic growth rates and the businesses deliver much better ROIC compared to its legacy businesses.
As machines will dominate the future, think robots, self-driving cars, deep learning, voice-recognition, algorithmic trading etc., IBM's two flagship products for this future Bluemix and Watson are positioning the company to be a leading player in the 21st century when it comes to analytics. As the SI segment is likely growing around 30% y/y from an already high base and is the key reason for investing in IBM. The SI segment also contains businesses that are easier to defend, which gives higher margins, as they require highly complex analytics and IP capabilities.
IBM targets $40 billion in total revenue from SI in FY18 up from $25 billion in FY14. Based on analysts estimates for FY18 revenue the SI segment would account for around 48% of total revenue. With revenue the last 12 months of $87 billion and a large segment of more than $25 billion is growing at 30% y/y the future revenue forecasts are obviously too conservative and here lies the opportunity. Analysts are too negative on IBM focusing too much on the short-term headwinds instead of the long-term perspective of SI.
Valuation looks attractive
The trailing EV/EBITDA is 8.6x which is historically low and below S&P 500 at 12.1x. The discount makes sense from the top line growth rate, but the underlying growth in the SI segment on top of expanding margins and ROIC already standing at 26.5% which is significantly above its peers, the stock looks very cheap.
As momentum builds in its SI business and investors open their eyes for the future of machines and predictive analytics there will be a major re-pricing of IBM's valuation. Adding exposure to IBM at these historically low valuation levels seems attractive for the long-term investor.
All our alpha picks across the mid, large and mega cap segments among US and European equities can be found the attached PDF.
– Edited by Clare MacCarthy
Peter Garnry is head of equity strategy at Saxo Bank