With Iffy Momentum, IBM Looks Expensive

By Stephen D. Simpson, CFA | April 19, 2012 AAA

For better or worse, IBM (NYSE:IBM) has finally gotten its due as a soup-to-nuts play on global IT spending. Unfortunately, that attention has pushed up multiples and driven a lot of the excess value out of the shares. While IBM remains a great stock to hold for the long haul, a combination of iffy near-term earnings momentum and stretched valuations could pressure the shares in the near term.

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In Line, but Not Really Strong
IBM had an OK quarter that basically fit the pattern of past years (a steep sequential decline from Q4 to Q1). Revenue was basically flat with last year, though, as hardware revenue fell 6% (constant currency), software rose 7% and services rose just 1%.

Gross margin did pick up about a point from last year, and operating income rose about 5%. IBM was efficient with its SG&A and R&D spending, but it was the lower-than-expected tax rate that boosted reported EPS over the average analyst estimate.

SEE: Getting The Real Earnings

Hardware Still Grinding
Exiting 2011, the expectation was that tech hardware would slow in the first half of 2012 and that seems to be happening. Mainframe sales (which are often volatile) fell 24% on a tough comp, while storage fell 4% and servers were flat. In the server business, that suggests some headwinds for Hewlett Packard (NYSE:HPQ) and Dell (Nasdaq:DELL), while the storage performance may well be a sign of more share gains for EMC (NYSE:EMC) and NetApp (Nasdaq:NTAP). Although IBM's hardware business is likely to remain a little sluggish, it's important to remember that it's a pretty small (about 15%) part of the business.

Software Gaining
IBM's hardware business is probably matching the market, but the software business seems to be gaining share and growing faster than the broad market. It certainly helps that IBM is a leader in many of its addressed markets; according to Gartner's Magic Quadrant methodology, IBM is a leader in 60 categories - nearly double that of Oracle (Nasdaq:ORCL) and three times that of Microsoft (Nasdaq:MSFT). Although information management and Tivoli were a little sluggish (up 5%), the broader middleware category was stronger (up 8%).

Services Slowing?
IBM's services business is likely to generate the most discussion coming out of this quarter - which is not surprising as it is so large (more than half of revenue). Revenue was up just 1% this quarter. While 15% growth in service signings looks encouraging, IBM management has said in the past that backlog levels were more indicative of current momentum and the service backlog was down 2% this quarter.

At this point, I would not panic or worry too much about this state of affairs. True, Accenture (NYSE:ACN) delivered a better revenue growth number, but the bookings growth was inferior. Infosys (Nasdaq:INFY), though, had a weaker quarter and brought numbers down. So at this point I would speculate that it's more of a market slowdown than a share shift.

SEE: A Primer On Investing In The Tech Industry

The Bottom Line
IBM is a strong player across the board in IT, but as large as it is, it is hard for the company to swim against the tide and the IT market seems a little more challenging at present. I don't expect much to change about this company, though. While Big Data is a potential threat to every company, IBM has a reliable history of evolving with the times, anticipating customer needs, and making judicious acquisitions to fill in the blanks.

Even allowing IBM a lower discount rate than I would normally give to a large tech company, IBM shares look expensive. Should IBM match its trailing free cash flow growth rate over the next decade, the stock would still only be about 10% undervalued. I would not rush to sell any IBM shares I owned, but new money can find better homes today.

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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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