Why IBM Shares Jumped 9% in a Day

10/25/17

Courtesy of Motley Fool

In this segment from the MarketFoolery podcast, host Chris Hill, Jim Mueller of Stock Advisorand Motley Fool Options, and David Kretzmann of Motley Fool Rule Breakers and Supernovaconsider the latest status report from transforming tech giant IBM (NYSE:IBM).

Yes, it's total revenue fell -- again -- but in its four "strategic imperatives" units, the top line rose 11%, and those growing, future-focused businesses are almost to the point where they account for half of sales. Is the tipping point in sight?

A full transcript follows the video.

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This video was recorded on Oct. 18, 2017.

Chris Hill: IBM, despite the fact that IBM's streak is intact, and when I talk about IBM's streak, I'm referring to -- this is the 22nd consecutive quarter of falling revenue for IBM, and somehow, David, shares of IBM, up 9% today. What's going on here? First of all, they could have had an amazing quarter. They could have broken the streak, and I still wouldn't have expected the stock to be up 9%.

David Kretzmann: Yeah, I think in this case, it's just, low expectations can be a wonderful thing for a stock in the short term. In general, this is a similar story for IBM. You have what's really been a struggling legacy mainframe hardware and software business, trying to transition into the age of artificial intelligence with Watson, cloud computing, things like that. So they are continuing to see some progress with their strategic imperatives, so you know it's important. [laughs] Those are their new businesses like cloud computing --

Hill: Wait. Please tell me that that's a name of one of their business units.

Kretzmann: That's all their up-and-coming important businesses. Cloud computing, artificial intelligence, Watson applications, things like that. Kind of all the new sexy stuff. For this quarter, strategic imperatives, all those different segments and businesses grew 11%. So, not knocking the cover off the ball, but it's at least growing. It's not dropping. And that segment now makes up 45% of total revenue, so it's getting closer and closer to a tipping point where you could see the company returning to growth, and hopefully they can end that unfortunate streak of 22 straight quarters of sales declines. Their cloud revenue, narrowing in on that, was up 20%. But in general, even with that growth of strategic imperatives, they're still seeing their margins decline. But the pace of the decline is slowing. If you want to find a silver lining there, that could be one.

I thought it was interesting to take a step back and compare IBM and Microsoft (NASDAQ:MSFT), because back in 2009 or so, these companies were about the same size, about $150 billion market value. They're producing roughly $16 billion in free cash flow. That was back in 2009. Eight years later, today, IBM is producing less free cash flow, less than $13 billion in free cash flow. Microsoft, over $31 billion in free cash flow. IBM's market cap today is still around $150 billion. Microsoft had a nice $600 billion.

So you can just see the trajectory of those businesses, which were in similar positions, where they had a legacy business that was producing a lot of cash. But both of them missed the initial transition to things like mobile, cloud computing, artificial intelligence. Microsoft, under the leadership of Satya Nadella the past few years, has really had a resurgence in a huge way, but IBM is still trying to figure out its identity as these new initiatives grab hold. But it seems like, with those strategic imperatives moving in the right direction, there's still reason to be optimistic that IBM's worst days aren't necessarily ahead yet.

Hill: It's a great point about Nadella, because when he was brought in to replace at-the-time longtime CEO Steve Ballmer, there was not necessarily any reason to expect the type of performance we've seen over the last few years from Microsoft. And I think it is an indication of how important leadership is. It's still, with IBM, a $150 billion business. They still have plenty of things that they can do. And maybe, if they get the right leader in there, that's the catalyst to move things along.

Kretzmann: Yeah, I think it's a company that can still be relevant. But like I said, I think they're still struggling to find their identity. At this point, they're spending more each on dividend payouts and stock buybacks than they are on capital expenditures. They're basically sending more money out to shareholders than they're investing in the business. I think, in a case like this, where you really do need to be investing to be on top of these emerging trends, I would hope they would prioritize their capital expenditures a bit more. But they still have a lot of cash. They have a lot of levers they can pull. So I can understand, given the low expectations, why the stock is popping a bit today.

Hill: Nine percent, though.

Kretzmann: That's a lot. But looking at the past couple of years, it hasn't been a pretty story for IBM.

Hill: Again at some point, in the next, say, conservatively, five years, I would bet that they break this streak. And what a party it's going to be then.

Kretzmann: Hey, something to look forward to.

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