IBM's Growth Formula--And How it Stacks Up

Michael is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

International Business Machines (NYSE: IBM) seems to have a working formula: for years now, the company works to quite often boast heavy gains in earnings, yet simply adequate-to-minimal revenue growth. Still, International Business Machines recently announces their 6% increase in profit with this very formula, seeing net income climb to $5.8 billion while revenue was just $29.3 billion, down $.2 billion from last year. (Granted, excluding the revenue gathered from their computerized cash register business—sold to Toshiba TEC later that year—would put their revenue numbers from last year about equal to this year.) So, how did IBM beat Wall Street analysts and send their stock up almost five percent that day? Let’s take a look.

Analysts had slightly lower expectations than they maybe should have had: concerns about potentially low growth in China as well as hesitation about the effect of Europe’s staggering economy and the ever-present fiscal cliff fear may have factored into lower expectations for technology companies in the fourth quarter. However, IBM reported that there was no evidence of a drop in Chinese growth. A.M. Sacconaghi, an analyst for Sanford C. Bernstein, remarked that “relative to the worry that was out there, investors feel good about it.”

Investors aren’t the only ones. The company’s chief financial officer, Mark Loughridge, identified the quarter as one that was “very, very strong” for I.B.M., noting that it marked the end of a record-breaking year in terms of profit, cash flow, and earnings per share.

It wasn’t all perfection for the largest supplier of information technology, though. Their hardware revenue fell 1 percent to $5.8 billion, plagued by the loss of that computerized cash register business. I.B.M. saw a 2 percent slide in revenue for its big technology services business, landing at $15 billion. However, massive cost cuts allowed for the division to still see a rise in profit.

In fact, cost-cutting was a major theme at IBM last quarter. Mr. Sacconaghi attributes the great results to relentless cost-cutting in addition to share buybacks, and lots of ‘em. IBM spent $12 billion last year alone buying back shares of its stock. However, they were adamant that this was not at the expense of important investments, like those in innovation or growth. He cited the company’s history, noting that it spent $19 billion on research and development since 2010. He reinforced this, saying “we’re plowing investments hand over fist into the business.” He admitted that the company has spent $11.5 billion on acquisitions in the past three years, mostly on companies dedicated to specialized software.

Their investments have paid off so far. They put a significant chunk of money towards mainframe innovation and research over the past year: a division which saw a 56 percent surge in sales thanks in part to the zEnterprise EC12, a completely new line of mainframe computers, which commenced shipping in September.

Despite hardware sales difficulties, IBM was carried by software sales, seeing growth in this division by 3.5 percent to $7.9 billion. In fact, Mr. Loughridge admitted that more than half of the company’s revenue in their high-growth businesses comes from where profit margins are highest: software.

So, has IBM earned its way into my portfolio, and should it be in yours?

I hesitate before clicking “buy” on IBM so quickly. A formula of low-to-no revenue growth year over year seems…weak. IBM has found a way to make it work by consistently cutting costs and, in this case, relying on low analyst expectations. Many investors, me included, still believe that growth of software sales will slow in Europe and China, and that hardware sales will continue to slip. These few things seem like a couple of flags, certainly for the long run. However, if IBM can keep up their incredible software sales and continue to cut costs while raising profit as much as possible, they are surely a viable short term option. They certainly can be a great long-term option too: they have a large competitive advantage over so many competitors in many of their new businesses. Let’s see how they plan to use it in the coming months.

The reason I remain so critical of the weak year-over-year revenue growth of IBM is because the company’s -1% “growth” in the category falls far behind the industry average of 8%. However, rival Accenture (NYSE: ACN) boasts only a 2% growth, which isn’t anything to gawk at, yet it’s still better than negative results. Accenture also prevails in year-over-year earnings growth, however, because of its cost-cutting ability; IBM claims a 70% advantage over Accenture in terms of their profit margin.

Hewlett-Packard (NYSE: HPQ), a competitor of the hardware variety, loses out in each of the aforementioned statistics. Granted, the hardware division of IBM isn’t going swimmingly either, but HP’s -7% year-over-year revenue growth and -11% profit margins fall miserably in comparison to IBM’s hardware division alone.

So, IBM’s profitability can strongly be attributed to their impressive ability to cut costs. However, how long can that last? How long can IBM remain profitable? How can competitors like HP and Accenture continue to stack up? The coming months will certainly prove an interesting challenge for all three.   

Michael Nolan has no position in any stocks mentioned. The Motley Fool recommends Accenture. The Motley Fool owns shares of International Business Machines.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

blog comments powered by Disqus