- Watson will do very well in the healthcare sector. Expect more acquisitions in this space as IBM continues its search for data.
- Bears are focusing on stagnant revenues over the last 10 years but ignore margin levels and earnings.
- Market will revalue the stock once its sees Watson's penetration where its learning and engagement abilities will begin to shine.
Even though International Business Machines Corp. (NYSE:IBM) reported an earnings surprise and revenue beat on the 18th of April for its fiscal first quarter earnings, the bears are again out in force humming the same tune that the top line has now been decreasing for the last 16 quarters. In fact, despite the strategic imperatives division now making up 37% of the company's revenues, bears quickly pointed to the facts that 1) the legacy business continues to decline (predicted), 2) the implied Q2 EPS guidance of $2.85 from IBM is well below consensus and 3) the first quarter earnings beat didn't result in improved guidance for 2016. Furthermore, bears are stating that "one off events" such as the Japanese tax rebate, currency fluctuation and acquisitions all helped IBM push itself higher in the quarter but these tailwinds may not exist in forthcoming quarters.
Earnings meant that the stock price tumbled by around $8 to around $144 and many believe it is only going lower despite its bounce since earnings were announced. If we look at the chart we can see that the 50-week moving average is right at support. Furthermore, the stock has had a powerful rally since February and earnings always had the potential to induce a correction due to temporary overbought conditions. Personally, I believe IBM's story hasn't been written yet which is why shorting at these levels still poses plenty of risk.
Firstly, IBM's legacy divisions may be in a secular decline but IBM's Watson will continue to grow meaningfully going forward. Cloud revenue reached $2.6 billion in the first quarter (a 36% increase) and I only see Watson growth in the health division expanding meaningfully. Why? Well, just look at the growth the biotechnology sector has undergone in the past few years (up over 300% since 2009) and now with the S&P 500 (INDX:SPAL) breaking out to new highs, I believe biotech will lead the bull run in the next few years. It's fundamentals stack up in the context that health care reform is resulting in more patient volumes and furthermore, acquisitions (like we are seeing in IBM's strategic imperatives divisions) in biotech are not slowing down which again illustrates bullishness in my view.
The shelling out of $2.6 billion for the recent Truven health acquisition will end up becoming a good investment in health especially when you see how Watson's versatility is being used across the whole health sector. Watson is now working with over fifteen cancer institutes where the super computer will be used to filter websites and help doctors give personalized treatments to their patients. On the biotech side, Watson is being used to match patients with different clinical trials. If Watson can have any success here, one would feel it would be very bullish for IBM as this sector is an enormous sector and as stated previously - biotech activity is not slowing down but rather ramping up. Remember Watson will become better from the increased information and engagement it will have access to going forward. This will all add up to very individualized treatment plans for patients which over time will make it a far more valuable tool and earnings growth always follows increased value irrespective of whatever industry you are operating in.
Moreover, bears are stating that because legacy businesses (where most of Big Blue's cash flows come from) are declining at a big clip, large dividend increases and stock buybacks will come under pressure in the years ahead. I don't buy it. Why? Because investors are taking a short term view instead of looking at this stock over a 10 year period. Since 2005 sales may be flat (primarily due to IBM divesting low-profit businesses) but earnings per share have grown from $6.11 in 2006 to $13.42 in 2015. Gross margins and operating margins are also well up and IBM's current earnings multiple is much lower now (10.6) compared to 16.6 in 2006. Now is a far better time to invest in this company than 2006 but because the masses don't see growth "yet", it is being signaled out as a sell. Remember that the market projects future earnings. We have had a nice rally which will continue in my opinion in the near term.
Although security segment revenue increased by 18% in the first quarter and new jobs are being created on an ongoing basis, I still believe Watson could be the star in 2016. Just look at the amount of acquisitions Big Blue has done in this space (see chart). The goal is clearly data and in the information age, data is extremely valuable.
However, I would caution investors that the almost $10 billion invested in analytics will take time to bear fruit. It takes time for businesses to get fully behind new software but if we base Watson's potential on the growth it has experienced in signing up customers (went from 18 in 2014 to 47 in 2015 to presently just under 100), the future looks very bright. It may be better to go long on IBM stock now before the market wakes up and really takes note of Watson's potential.
To sum up, I believe again that the bears are wrong about IBM and, at the current levels, the stock may still end up being cheap in the long run. The healthcare and biotech sectors have excellent fundamentals so Watson should definitely gain some traction there. The ship is turning slowly but the company is investing in the right areas which is why I'm still bullish on IBM stock despite the bearish commentary.