Investing is a game of perpetual worry, so there's nothing especially novel about the concerns over the health of IT spending in 2012. The benefit of this to IBM (NYSE:IBM) is that the company is so diverse, so long as there's some spending it will be OK. Moreover, while that pesky "peak margins" argument/worry seems to be popping up again, the company's momentum in software seems encouraging for near-term results.
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Good Enough Results for Q4
IBM didn't blow out the doors for the fourth quarter, but they did well enough. Reported revenue rose about 2% and it would seem like most of the revenue shortfall vis a vis Wall Street estimates was a byproduct of foreign currency - something notoriously difficult to model. Software led the growth (up 9%), while service revenue was OK (up 3%) and certainly better than hardware (down 8%).
With more revenue coming from higher-margin businesses, it's not hard to see how IBM wringed more profit leverage out of results. Gross profit improved almost by a full point, while reported pre-tax profits rose nearly 5% on a 70bp improvement in margins.
A good stand-by for bearish analysts and investors who can't otherwise elucidate a clear negative thesis is the "peak margin" story. Simply put, this is the idea that a company/industry/economy has squeezed out all the fat that is there to be squeezed and that there's just no way to keep up the leverage. (For related reading, see Operating Leverage Captures Relationships.)
With IBM, that concern is often focused on services. I can sort of see where the skeptics are coming from. Compared to consulting and IT service names like Accenture (NYSE:ACN), CommVault (Nasdaq:CVLT) or Computer Sciences (NYSE:CSC) IBM does indeed have very good margins. However, the company will be hard-pressed to match the Indian rivals like Infosys (Nasdaq:INFY) that can take advantage of lower outsourced labor costs.
I'm generally skeptical of arguments that run along the lines of "things can't get better, because they've never been better than this." After all, what of those predictions of yesteryear that New York City couldn't possibly grow more (or the streets would be buried in horse dung) or that automobiles were doomed to fail (because the human body couldn't withstand speeds above what a horse could produce)?
Hardware a Concern, But Not a Worry
IBM did report a notable weakness in hardware and that has some potential implications for the tech space. Servers seemed weak, and that's not great news for Hewlett-Packard (NYSE:HPQ) or Dell (Nadsaq:DELL); especially if IBM's results are being goosed by migration away from HP hardware in the wake of Oracle (Nasdaq:ORCL) dropping support for certain HP products.
Storage was likewise soft, due in part to disruptions tied to hard drive availability. Arguably this is a bigger risk to NetApp (Nasdaq:NTAP) than EMC (NYSE:EMC), but it suggests that the lower-end markets could be soft.
Last and not least is the mainframe business. Results definitely weren't strong (System z sales were down 31%), but this is probably more of a pause between cycles than anything more troubling.
The Bottom Line
On admittedly conservative estimates (a 10-year forward free cash flow growth CAGR of about 5.5%), IBM looks only slightly undervalued. With other tech hardware names trading at significantly larger discounts to fair value, it's hard to argue for putting new money into IBM. (For related reading, see Compound Annual Growth Rate: What You Should Know.)
As for whether to keep holding IBM, that depends on the original expectations that went with the purchase. Investors who bought back in the "IBM is doomed" days have a nice gain to show for their contrarian play, but IBM really isn't a turnaround story anymore. On the other hand, investors who bought IBM as part of a high-quality, lower-volatility portfolio don't need to be in any rush to change things up.
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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.
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