- Revenues will increase meaningfully at IBM over the next few years, but the jury is still out on earnings growth.
- Watson is the key to IBM's future, and IBM stock could be an all or nothing play on Watson.
- IBM carries more risk as an investment than other tech stalwarts. What's on offer is a high dividend and a cheaper valuation.
International Business Machines (NYSE:IBM) third quarter results illustrated that the company is finally getting close to revenue growth, which speaks volumes about the growth in its 'strategic imperatives' division. Nevertheless, growth in the segment (which now makes up 40% of revenues) has come at a cost and this is something Wall Street is noticing. IBM stock looks more and more like an all or nothing play on Watson. Here's why betting on IBM can be risky, but worth considering.
Top line revenues came in at $19.2 billion, which was only 0.3% behind the same quarter's figure in 2015. Gross profit margins in the third quarter slumped to 46.9%, which means the company's trailing 12 month average is 48.4% (down from 50% in 2014). Furthermore, operating margins have also taken a hit. The company's current trailing twelve month average is 16.4%, which is a sizeable 4.2% lower than the 20.6% number recorded in 2013. Therefore, when you couple the company's declining margins alongside the false boost in EPS in the third quarter (from a lower tax rate & IP income), you are looking at a company that is still heavily in transition at present.
IBM Is Buying Growth In Its Strategic Imperatives Division
The problem that I have with IBM at the moment is that the whole 'strategic imperatives' segment has fierce competition, which will only intensify in the years to come. There is no doubt that areas such as "Cognitive Solutions" and the "Cloud" will continue to hold their own going forward, especially due to IBM's current acquisition rate. This is why I don't see a problem with its revenue growth, due to the $5.4 billion already invested in acquisitions thus far this year. However, IBM faces fierce competition from companies such as Microsoft (NASDAQ:MSFT) , Oracle (NYSE:ORCL) and Alphabet Inc-C (NASDAQ:GOOG) that will keep spending at similar levels (if not higher) to develop their own technologies. Therefore, the question that arises is whether IBM can grow its margins in a competitive environment such as this. Remember, IBM became a powerhouse in the tech sector because of the huge switching costs associated with its hardware, software and services. I don't see the same stickiness with many of the imperatives (Security, etc) despite their robust revenue growth at present.
More The Acquisitions, More Valuable Watson Should Become
Watson is the one area that has the potential to definitely stand out from the competition in years to come . IBM doesn't disclose Watson's quarterly or annual revenues but the investment that has gone into this in recent times should illustrate to investors the huge potential in this area. Down through the decades, IBM has always prided itself on making big bets and Watson could end up being the biggest of the biggest. For example, the Swiss bank UBS estimates that Watson will do about half a billion Dollars in top-line revenues this year, and that this figure has the potential to grow to $17 billion by 2022. IBM's bet is that if it can funnel as much valuable information and data into Watson as possible, the service will improve exponentially, which will ultimately deliver a meaningful increase in operating margins over time.
Betting On IBM Is A Bet On Watson
In this rapidly changing sector, the companies that are going to be the most successful will be the ones with the highest switching costs. If Watson can deliver on its promise, which is that it will be used en masse, across multiple sectors in the world, then this will give IBM a strong competitive advantage in the AI space. Furthermore, IBM has stated clearly that Watson will only be available on its own cloud (and not competing ones) which again is a strong statement of intent by the management.
IBM Is A Cheap Stock In Tech & Pays Out An Above-Average Dividend
Personally though, I feel IBM carries more risk than the likes of Microsoft and Amazon, which are growing their cloud infrastructures rapidly. However the investor in question is getting paid in a sense to take this risk. Why? Because the company's earnings multiple of 12.7 is currently over four points below the industry average. Moreover, the company is currently paying out a dividend that translates to a yield of 3.47%, and is increasing its dividend at an attractive annual growth rate of 12.5%. Therefore, I see IBM as a more speculative play in the tech landscape. It doesn't seem to have as much downside protection as Amazon on or Microsoft, but it is much cheaper and pays a lofty dividend. Success in Watson will make or break this company. As usual, it's all or nothing with IBM.
IBM's margins have suffered in recent quarters and analysts are unsure if they can bounce back to previous levels. The risk/reward setup here is interesting. On one hand, I feel the company has less downside protection compared to the likes of Amazon, but on the other hand, it is much cheaper than the other options in the market and is paying a strong dividend. Position sizing is key here in case Watson doesn't deliver on its promise.
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