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Morningstar | IBM Posts Underwhelming 3Q Results; Juggling Act Continues; Shares Modestly Undervalued

IBM posted an underwhelming third-quarter result with the firm continuing to perform its juggling act across higher growth strategic and low-to-declining nonstrategic business lines. While management was quick to highlight areas of growth and margin expansion, the firm’s ongoing challenge with legacy revenue streams was apparent and we were particularly surprised by the level of weakness in the firm’s cognitive solutions business. Within cognitive solutions, both solutions software and transaction processing software posted notable declines owing to challenges in areas like collaboration, commerce, and Z middleware. To that end, on the Z mainframe front, we expect IBM to face tougher growth comparisons given the successful launch of the z14 mainframe line toward the end of last fiscal year and a future sales lull due to the cyclicality of what we determine is a secularly declining mainframe business. However, on a positive note, IBM’s services businesses showed good signs of improvement with digital transformation demand leading to growth for areas such as consulting and infrastructure services.

After slightly adjusting some midterm assumptions, our fair value estimate remains $168 per share on this narrow economic moat name. Investor sentiment remains low on IBM and we think the company is trading at a modest discount (current price implies a fiscal 2018 adjusted price/earnings ratio of 10 times), which may appeal to risk-seeking technology investors.

For the quarter, reported revenue fell 2% year over year to $18.8 billion (was flat in constant currency). The strengthening of the U.S. dollar was an obvious headwind, but other headwinds included declines in solutions software, transaction processing software, technical support services, and operating systems software. We expect some lumpiness and cyclicality within these business lines given client purchasing cycles and linkages to other areas like hardware sales. Therefore, we expect some ongoing short-term weakness around these businesses. Strategic imperative revenue grew 11% year over year in constant currency and on a trailing 12-month basis totaled $39.5 billion. Strategic imperatives are expected to be a midterm growth driver, but we have been expecting, and are now witnessing, a slowdown in the annual growth rate. Still, it remains one of the only viable growth options for IBM if it is to achieve even modest midterm revenue growth.

IBM’s non-GAAP pretax margin improved 50 basis points year over year to 19.2%. The modest improvement was driven by acquisition synergies, a shift to higher value services, scale efficiencies, and better resource allocation. We expect IBM to be laser focused on operational efficiencies over our explicit financial forecast and assume modest year-over-year pretax margin expansion.