- IBM CEO Virginia Rometty's strategic imperatives are already contributing to 37% of revenues.
- It's only a matter of time before new growth offsets legacy revenue decline.
- How long will that take, and is this the right time to invest in IBM?.
International Business Machines Corp. (NYSE:IBM) is approaching a major cusp in its business history - the transition from legacy-heavy businesses that are declining to future-ready divisions that are growing quickly and sustainably.
The biggest question now is this: how long before IBM starts showing top line growth again? In this article, we’ll look at some of the numbers reported for 1Q 2016 and try to arrive at a timeline for that transition to come into full effect.
Except for a brief growth period between 2009 and 2011, IBM has been showing negative revenue growth since 2008. They’re currently at the lowest level they’ve been at since that time. When Virginia Rometty took over in 2012, her mandate was to deliver new growth drivers in a sustainable and profitable manner.
To the untrained eye, it looks like that hasn’t happened yet. But if we look a little closer at the numbers, it tells a different story.
Q1 2016 Revisited
The biggest problem the company faces is that its legacy lines of business are declining at a faster rate than their new businesses are growing. The new lines of business, Rometty’s “strategic imperatives”, are the vehicles of IBM’s major transition. Those vehicles may be showing healthy growth signs, but turning a 100-year-old business around isn’t going to happen overnight.
So how long will it take?
To answer that, let’s look deeper into their first quarter of this year.
The first significant change is the reporting segments themselves. The new revenue groupings better reflects the direction the company is taking.
Source: IBM Quarterly Release
The second point is that despite reporting strong numbers and growth on new businesses, overall segment revenues are still dropping.
Source: IBM Press Release
That means the new businesses within those reporting segments haven’t caught up with declining legacy revenues. But a clue as to when that will happen may lie in the numbers themselves. Q1 may not be showing the kind of top line recovery we’d like to see, but it does give us enough insight into their two biggest stars: Cognitive and Cloud.
Source: IBM Q1-16 Report
These two segments are critical to IBM’s recovery. Along with tech services, they bring in 66% of the company’s revenues. As a subset of that, strategic imperatives bring in 37%.
Source: IBM Quarterly Release
That 37% represents $7 billion for the quarter and $30 billion on a trailing twelve months basis, with cloud and cognitive solutions forming the pillars.
Assuming a constant 17% YoY growth, in two years that $7 billion will grow to nearly $9.6 billion, or a run rate of $38 billion. That’s the point at which growing revenues will catch up to declining ones, and IBM’s top line will once again start to grow after an incredibly long hiatus.
But this time, the numbers will be here to stay, because cloud and cognitive solutions are representative of how businesses of the future will depend heavily on cloud services and the ability to decipher and understand structured and unstructured big data.
The storage, analysis and visualization of that data, along with predictive models built around Watson’s capabilities, will form the core of IBM’s revenues. Of course, legacy businesses will remain for several years yet - they’re not going to completely disappear. A significant number of businesses will continue to run on traditional models of data handling, and I suspect IBM will ultimately reach an equilibrium in those segments.
The Profitability Angle
The thing investors need to keep their eyes on is how revenues from strategic imperatives follow the growth curve up to that $10 billion per quarter mark. But there’s something else to keep in mind, which is the other part of Rometty’s mandate - to make IBM more profitable as a business.
That profitability is already at one of the highest levels it’s been in the past ten years. Operating margins have been maintained around the 19% mark since Rometty took over, and gross margins are at around 50%.
The Investment Case
That’s the business IBM is turning into - a forward-looking company standing on forward-looking technologies and capabilities that were built from the ground up. The combination of Watson, SoftLayer, Bluemix and the various service models built around them will become the new growth drivers of IBM’s future.
Given the current growth rate of the strategic imperatives and the decline rate of legacy lines of business, I see IBM showing top line growth in two years or less. The shortening of that time frame depends on how effectively the company is able to drive growth in those key areas while optimizing support revenues such as tech support, consulting, process services, application management and so on.
If you’re willing to wait it out, my recommendation is to BUY now while market expectations are still low - something that a forward P/E ratio of around 11 indicates. With a dividend yield of 3.6%, the stock should give you some healthy returns while the transformation happens.