- IBM's huge liabilities are made up of $30 billion of global financing which is debt backed by receivables (loans).
- Between 2009 and 2012 IBM's debt to equity ratio deteriorated but earnings and the share price flourished.
- Sustained Strategic Imperatives growth will eventually offset declines in Legacy & IT.
The IBM (NYSE:IBM) bears are out in force again after the company announced fresh job cuts which according to reports took place on a massive scale. Multiple areas are currently being impacted (AA CMS cloud division, Global service parts, etc) and severance packages are said to be well below what the company paid out in the past. So the question remains - is this a sign of desperation on the company's part or a sign of strength for taking bold action?
The answer to this question won't be known for some time but my recommendation is to remain long for the time being especially if you are primarily invested for the dividend. Why? Well, although the company is undoubtedly getting smaller, the company still generates an enormous amount of free cash flow every year ($13.43 billion last year) which explains the company's expansive buyback plans and dividend growth levels. Furthermore, the company is having an excellent run with its share price up 17% over the last 30 days. (see chart)
As IBM continues its transition to become a smaller company whose aim will be to grow faster, not all things are negative in my view. I still see this company as a value play rather than a value trap and in this article, I will point out why I believe this is the case.
First of all, when evaluating a value play, it is important to look across the whole spectrum of its valuation and income metrics. IBM currently has an earnings multiple of 10.3 and a sales multiple of 1.7 which are both at least 20% off from their 5-year averages. Furthermore in 2015, the company generated $13.43 billion in free cash flow which explains why this company is well capable of delivering double-digit growth in its dividend hikes every year.
Net income more or less mirrored free cash flow in 2015 (both over $13 billion) and with dividends and share buybacks costing the company a net $9.19 billion, it is easy to understand why income investors continue to be attracted to IBM stock despite recent buybacks not being able to keep the stock elevated. The final metric which is crucial when evaluating a value play is debt and this is where the bears are making themselves heard.
At the end of 2015, IBM reported equity of $14.42 billion on liabilities of $96.07 billion which gives a high debt to equity ratio of 6.6 (if we include all liabilities). However, out of this $96.07 billion, global financing debt came to $27.2 billion which is also recorded on the balance sheet as a liability. Global financing debt is basically borrowed funds loaned out (IBM pockets the difference) to customers and is secured by the "receivables" tab on the balance sheet. Therefore, if we exclude global financing debt from the company's liabilities and just include interest bearing debt in our calculation, we now get a debt to equity ratio of under 2.34 which is more respectable.
Furthermore, we have seen from IBM's past that rising debt to equity ratios are not necessarily a bad thing. Between 2009 and 2012, the debt to equity ratio spiked from 0.97 to 1.28 but earnings, revenues and the dividend pay-out rose meaningfully in this period. Furthermore, the share price went from $87 a share at the start of 2009 to almost $200 a share by the end of 2012 illustrating that when debt is managed well, it doesn't necessarily have to affect earnings or share price growth in an adverse way.
Moreover, investors should also note that equity increased by 20% in 2015 (up from $12.02 billion in 2014) which the market may take as bullish in its expectations. Cost cutting, becoming more efficient and paying off long-term debt are all usually seen as prudent actions by the market despite the probable fact that the company will be affected in the near term.
IBM's "Strategic Imperatives" division may only have grown by 16% last quarter but I'm expecting much better growth in its next set of earnings which will be announced on the 18th of April as I believe seasonality played a role in the fourth quarter. The "cloud" saw revenues of over $10 billion last year which should grow even more when you consider the number of acquisitions taking place in this space at the moment. IBM finished last year with $8.2 billion in cash on its balance sheet and recent news on the Truven Health acquisition will strengthen IBM's cloud business even more.
Bears need to realize that IBM nearly went out of business a few decades ago because they weren't bold enough when technology trends were changing. This time round, IBM wants to be at the forefront of the change and recent margin expansion hammers this point home comprehensively. Revenue may have dropped by $11 billion last year but earnings per share rose well over 10% to $13.42. Furthermore, Fitch ratings assigned an A+ rating to IBM's recent debt offering stating that it expects "Strategic Imperatives" to achieve sufficient growth rates which will eventually offset its slowing Legacy IT divisions.
The final risk I would mention in relation to shorting IBM stock is the dollar. Analysts expect the company to do $77.86 billion in revenue this year along with an EPS of $13.49. Now any weakness in the US dollar will most certainly increase these metrics which would definitely give way to earnings beats throughout 2016. Even if there isn't a structural change of IBM's business model in the near term, dollar weakness will increase earnings and the top line going forward. Furthermore, 2016 predictions were made when the dollar index was much higher than it is at the moment.
Mario Draghi's initial comments yesterday (about more bond buying) weakened the euro meaningfully but then the currency bounced back strongly when he mentioned that he didn't see interest rates going any lower from here. Could this turn out to be a floor in the euro and a top in the dollar? Time will tell but the US dollar has stretched quite a bit above its mean and over time I see this reverting to its historic averages.
To sum up, there are just too many moving parts to consider shorting IBM stock at the moment. Its valuation multiples are below average and its debt is manageable as confirmed by Fitch recently. Margins are expanding due to growth in cloud, data and engagement plus some dollar weakness from here would increase the top line, which has been badly damaged recently as a result of divestitures and negative growth in hardware and information technology. My recommendation is to remain long on this tech giant.