IBM: This Time Is Different
@IBM ‘s margins have been terrible for the past few years. But revenue declines have been responsible for nearly the entirety of the decline. That means that if revenue recovers, margins should follow. #IBM (NYSE:IBM) is a stock that I was bearish on for a long time. The company’s legacy businesses have been weak for years, and when it came to management, let’s just say I wasn’t exactly full of confidence. But in the past couple of quarters, IBM has shown some signs of life, and that led me to actually post a bullish piece on the stock after the Q3 report. That’s something I didn’t think I’d be doing in 2017 (or even 2018), but the facts have changed and thus, I have too. But despite the bullish talk of the SI businesses doing their part to grow revenue, IBM is still struggling with its margins, which is something I called out in my linked article as a principal risk the company needs to address. But how bad is it? In this article, using data from Seeking Alpha, I’ll take a look at IBM’s margin issues to see how bad they really are and if they could derail the bull argument. ￼ Note: the charts below were all created by the author using data from the linked source above. Some perspective on the issue Let’s take a look first at the last five years as well as the first three quarters of this year in terms of what IBM has been able to do with pretax margins. I prefer this measure because it doesn’t include things like IBM’s laughable (but favorable) tax rate or anything else that isn’t strictly related to running the business. Pretax income is a purer look at how a company is performing and thus, I prefer it to net earnings in some cases. ￼ What’s really interesting here is that IBM’s pretax margins were routinely in the 20% to 22% range in the early part of this decade, but since the decline began a couple of years ago, the fall has been precipitous. Two years ago, we saw IBM lose 100bps of operating margin, but 2016 saw a further 410bps decline, and this year, so far, has added another 320bps to the pain. These numbers are so ugly they are a bit difficult to believe, but IBM’s margin struggles are something that I pointed out a bunch of times when I was bearish; I typically don’t buy stocks that have margin numbers that look like this. The company’s legacy businesses continue to shed revenue at fairly high rates and that has deleveraged IBM’s operating costs, resulting in what you see above. In short, things have gotten ugly but as I said in my article after Q3, I also believe IBM is at or near an inflection point; more on that in a bit. 2016 was a tough year for margins Before we take a look at the implications of IBM’s margin woes, let’s take a look at what 2016 looked like in terms of the components of what makes pretax income move around for IBM. Then, we’ll compare those numbers to this year and see where the opportunities are for management going forward. ￼ ￼ Gross margin in the 52% range is pretty normal for IBM as that metric has moved around very little over the time frame we’re looking at. That’s actually pretty important to my argument that IBM’s margins could be on the cusp of improving because if gross margins were tanking, IBM would have two problems to solve and not just one. However, gross margins have held up pretty nicely over time and 2016 was no different. SG&A, however, is a different story. 2016 saw SG&A costs in excess of 31% as it has moved up every single year in our data set. If you’re keeping score at home, that’s not good, and it has been the single biggest reason why IBM’s pretax margins have deteriorated. The good news is that SG&A is the largest component of the income statement that a company can directly and most easily impact, and that is a big part of why I flipped to bullish on IBM. Not to make it sound trite, but in order to get SG&A back under control, IBM just needs revenue growth. That is easier said than done, of course, but revenue deterioration has been almost solely responsible for IBM’s margin problems. It follows, then, that if revenue is set to begin its recovery due to the success of the SI businesses, that margins would follow. The other, smaller portions of the income statement don’t move around all that much although D&A has also deleveraged over the years due to substantially lower revenue numbers. IBM is usually in the $4.5B area annually for D&A, and this year is shaping up to be no different. The problem is that IBM’s revenue has tanked since 2012, and that has led the steady D&A expenditures in dollar terms to look bigger and bigger as a percentage of revenue. The good news is that the fix is the same as it is for SG&A costs. This year has been even worse Moving on now, let’s take a look at the first three quarters of this year by way of comparison. ￼ Straight away, we can see that gross margin is 240bps lower so far this year than it was last year, and that’s a big departure from the rest of this data set. This year has thus far been the lowest gross margin number IBM has produced for many years, and it is due to the fact that IBM’s legacy businesses are losing pricing power and that its financing arm has produced much lower margins this year than in prior years. This is the first really meaningful decline in gross margins we’ve seen for years from IBM, but as I’ll explain below, I’m not alarmed because I think it will be remedied as the mix of business between old and new continues to shift. ￼ SG&A costs deleveraged once again as revenue has fallen; actual dollar costs of SG&A are flat YoY, give or take. I won’t rehash the argument I made above but just to reiterate, IBM’s margin problems are almost entirely to do with declining revenue. The story is the same with D&A costs in 2017 as it was last year and the year before that as well. But there is hope I don’t want to belabor the point, but the short version of the story is that IBM’s margins look horrible, but I think there’s cause for optimism. The strategic imperatives are nearly 50% of revenue and continue to grow at double digit rates. It won’t be long before SI revenue is over half of the company total, and that means that the shrinking legacy business won’t be able to do its damage to the extent that it has been in the recent past. In other words, I don’t think IBM is that far away from actually producing some semblance of revenue growth, and when it does, it will gradually pick up the margin leverage it has lost in the past few years from perpetually declining revenue. Why am I so confident? The reason those margins deteriorated in the first place was because of deleveraging from lower revenue. Thus, if I’m right about revenue growth, then odds are I’m right about margins recovering as well. That, ladies and gentlemen, is the bull case for IBM in my view. Now, I don’t want to sound gung-ho bullish because I’m not; IBM clearly still has some issues. But I do think that the days of constant revenue and margin declines are coming to an end, and that makes me like the stock here. The stock is going for just 11 times next year’s earnings, and analysts are expecting very little in the way of revenue or margin improvement for the foreseeable future, leaving ample room for upside surprises. However, with revenue growth from the SI businesses, I think that is exactly what will happen, and I’m betting these pretax margin numbers will look much better in a year or two than they do right now.