Reduced IT Spending Could Hurt IBM Stock

  • Reduced global IT spending has affected the overall traditional IBM business.
  • Its Cloud Computing Business has lots of potential but lags behind Amazon and Microsoft.
  • Investors Could Instead Buy an S&P 500 index fund to limit IBM downside risks.

According to research from Gartner, Inc., global IT spending in 2016 is expected to come in at $3.41 trillion which is expected to remain flat from the prior year’s levels. The report highlighted that many firms are starting to shift their focus to digital businesses, Internet of Things and algorithmic business. As a result, firms are turning to cost rationalization efforts, which means reduced capital resources spent on traditional IT services.

Data Center Systems, IT Services and software are expected to register modest gains during the period, with projected combined spending of $1.4 trillion. On the other hand, communications services and devices are assumed to register $2 trillion, offsetting gains from other segments.

This scenario in the IT spending space puts pressure on the viability of the International Business Machines (NYSE:IBM) business model. It is noted that majority of IBM’s segments, notably Global Business Service and Systems have experienced year-on-year decline in revenues in the 1st half of 2016, as shown in the below table. Overall, revenues for the first half of 2016 came in 4% lower than the prior year.

Table 1: IBM 1st half 2016 revenues per segment

In US$’MM 1H 2016 YoY growth
Cognitive Solutions 8,654 1%
Global Business Service 8,387 -3%
Technology Service 17,280 flat
Systems 3,626 -23%
Global Financing & others 976 -6%
Total 38,923 -4%

Source: 2Q 2016 IBM Financial Report

The silver lining is that cognitive solutions (i.e., cloud computing service) have been picking up steam, albeit at a slower pace than expected. Management has mentioned that the company is going into new IT-related business to shift gradually beyond the IT marketplace.

Also Read: Will IBM Stock Hit A Bottom In 2017?

The Future is in the Clouds

There exists a huge potential for IBM cloud computing services. In fact, the company has invested around $2 billion during 2Q 2016 to build new markets, although they are not totally abandoning their enterprise IT business where they have a strong leadership.

It seems that it could take a while before the company could derive major revenues from their cloud computing service. Additionally, other players in the market such as Amazon and Microsoft already have strong leadership in the market. Based on a Synergy Research study, IBM has only 8% in the cloud infrastructure market. IBM trails behind leaders Amazon and Microsoft who have 30% and 10% market share, respectively.

Given the relatively flat global IT spending and the fact that IBM’s main revenue driver would be the traditional IT businesses, the market should expect flat growth in IBM’s top line figures over the next 3 years. On the other hand, IBM’s free cash flow run-rate amounting to around $9 billion is still very good.

The only concern here is that the company pays out generous dividends and repurchase shares in the market, which could limit their future investments in the space. During the 1st half of 2016 alone, the company paid out dividends of $2.6 billion and repurchased shares amounting to $1.8 billion.

Also Read: Can Google Cloud Really Catch Up With The Cloud Leaders?

Warren Buffett Loves IBM

Berkshire Hathaway has followed IBM for over 50 years, but it was only recently that Mr. Buffett has invested in the company. He has publicly declared that he has never sold IBM shares and believe they need to buy more shares if the prices remain attractive over the next 12 months.

Also Read: Here’s Why Warren Buffett Continues To Bet On IBM Stock

The share price has dropped by 8% in last 5-years. This implies that the market has not been impressed by the lackluster revenue growth over the last few years. Revenues have declined from $107 billion in 2011 to $82 billion in 2015, while earnings per share have been relatively flat for the period, going from $13.06 per share in 2011 to $13.60 per share in 2015.
IBM stock chart

Source: IBM Stock Price Chart by amigobulls.com

Typical retail investors do not have the same "patience of capital" as Mr. Buffett. In fact, considering that it would not be surprising that net profitability will continue to remain flat in the coming years, it can be expected that more IBM investors switch to safer vehicles such as index funds to retain upside exposure to IBM while cushioning downside risks.

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