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IBM's Weak Results Hide Its Growth Potential

At first glance, International Business Machines' (NYSE: IBM) third-quarter results looked disappointing, featuring declining revenue and shrinking earnings per share. But as has often been the case with the giant tech company, one-time items again muddied the picture. And based on conditions in its underlying business, the stock may constitute an interesting investment opportunity.

Weak results

IBM's revenue declined by 3.9% year over year to $18.0 billion during the third quarter. But excluding the effects of foreign currency and divestitures, the top line fell only 0.6%. Still, the company's fifth consecutive quarter of revenue declines should worry investors, especially since this was the first time that figure included $371 million from IBM's $34 billion Red Hat acquisition. 

IT Technician with a Laptop Computer and Engineer Colleague are Talking in Data Center while Walking Next to Server Racks. Running Diagnostics or Doing Maintenance Work

Image source: Getty Images.

Also, IBM's GAAP operating margin dropped from 16.0% to 8.4%. And despite an effective tax rate of negative 9.9%, its GAAP net income decreased 38% year over year, from $2.69 billion to $1.67 billion. 

During the earnings call, management highlighted the point that they had cut the company's $73 billion debt load by $6.7 billion to $66.3 billion. But that success isn't as significant as management suggested, due to the decrease in cash and equivalents. Excluding the impact of the Red Hat acquisition on IBM's cash balance, its net debt decreased by only $3.85 billion compared to the previous quarter.

Temporary issues

Short-term challenges explain the quarter's negative results.

Revenue from IBM's systems segment, which includes servers and storage systems, dropped 14.7%. But that performance shouldn't surprise investors. The third quarter marked the end of an IBM product cycle -- the company started shipping its new mainframe z15 server during the last week of September. Thus, revenue from the systems segment should increase over the next several quarters.

The decline in IBM's global technology services -- GTS -- was more surprising. GTS consists of managed and outsourcing services, cloud-delivered services, and maintenance activities. Since this segment provided 38.8% of the company's total revenue at a gross profit margin of 35.8% during the quarter, its performance impacted IBM in a meaningful way.

Management pinned the 5.3% decline in GTS revenue on a lack of extra business beyond that which the segment booked prior to the quarter. But that should turn around since signings -- a leading indicator of revenue -- increased by 20% during the third quarter.

Growth on the horizon

Beyond the challenging short-term results, there are credible scenarios for IBM to deliver revenue growth.

Under GAAP rules, Red Hat contributed $371 million to IBM's revenue during this recent quarter, but had it remained an independent company, with the same underlying results, it would have reported revenue of $987 million. The difference arises from a rule that requires companies to recognize their acquisitions' deferred revenues at fair value. This has one important consequence: It will lower the amount of revenue IBM will recognize from its Red Hat acquisition over the next few quarters. But it will also give the company favorable comparisons further down the road.

In addition, since Red Hat was purchased, its normalized revenue growth accelerated from percentages in the mid-teens to 20%. IBM is already taking advantage of cross-selling opportunities to propose Red Hat solutions to its large client base. 

And taking into account the new product cycle in IBM's systems segment, management confirmed it is still targeting revenue growth in the mid-single-digit percentages over the medium term -- the same forecast it announced after the Red Hat acquisition.

A simple and attractive investment proposition

With only one quarter left in 2019, IBM's management still forecasts non-GAAP earnings per share and free cash flow to reach $12.80 and $12 billion, respectively, for the year.

At the time of this writing, the market values this tech stock at a forward P/E ratio of 10.2 and at a free-cash-flow multiple of 9.9. Those modest valuation figures indicate the market doesn't expect much growth. Thus, long-term investors should consider IBM as a slow-growth investment at a reasonable price.

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Herve Blandin owns shares of IBM. The Motley Fool is short shares of IBM and has the following options: short January 2020 $200 puts on IBM, short January 2020 $155 calls on IBM, and long January 2020 $200 calls on IBM. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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