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Thursday, October 17, 2013 - 14:30

5 Key Takeaways From IBM's Troubles

Thursday, October 17, 2013 2:30 PM

Here's a not-so-bold prediction: IBM (NYSE: IBM) is likely to be the next company in the Dow Jones Industrial Average to replace its CEO.

Since its board of directors appointed Virginia Rometty to lead the company on Oct. 26, 2011, IBM has steadily morphed from a technology leader to a cash cow. Innovation has been replaced by financial engineering, and the company's just-completed third-quarter conference call was an exercise in deep frustration as analysts fumed that Big Blue keeps delivering another set of missteps.

It's not Rometty's fault. She inherited a bloated behemoth. But it's hard to find any solid moves that might pave the way for a turnaround either.

In the eyes of investors, Rometty got off to a good start. She immediately tasked her charges with finding every opportunity to squeeze out profits, which pushed shares above $200 in early 2012 for the first time in company history. That time held another, more dubious distinction: IBM posted a revenue decline in the first quarter of 2012 and has yet to show revenue growth since.

At this point, analysts have moved their ratings to "neutral" or "hold," with price targets right around the current stock price. They are just being diplomatic -- because in the absence of any deep fundamental change, IBM's slide into irrelevance will only accelerate.

This isn't a company that can be fixed by a modest acquisition or a new piece of hardware. Instead, a breakup of the company into smaller, more focused segments might be the only answer. It's just a matter of time before IBM's board realizes that.

For investors, the IBM debacle holds several lessons:

1. Don't focus solely on EPS and price-to-earnings ratios.

Over the past year, IBM has been talking to investors about a goal of generating $20 in earnings per share (EPS) each year, perhaps by 2015. Shares trading for less than 10 times that goal have simply led investors into a value trap. In today's market, tech investors are focused on corporate strategy, industry positioning and, most of all, revenue growth. Though IBM has been making tentative forays into cloud computing, virtualization, Big Data analytics and other hot tech niches, few would consider the company to be a trend-setter in any niche.

2. Size for its own sake is irrelevant.

IBM's success over the past few years was predicated on its ability to be a one-stop shop for clients. The company's many acquisitions over the past decades were never part of a grand vision -- they were instead made simply to fill a hole in the product line.

Trouble is, today's IT managers are more squarely focused on the performance of each piece of hardware and software they buy, ponying up for best-of-breed suppliers. That's a lesson that has already been learned by Hewlett-Packard (NYSE: HPQ) and Dell (Nasdaq: DELL), both of which also pursued a "soup-to-nuts" strategy.

3. Service is a commodity.

Companies like IBM, Computer Sciences (NYSE: CSC) and Electronic Data Systems (now owned by HP) landed massive service contracts over the past 15 years as Fortune 500 companies began to outsource all non-core administrative functions. Yet in recent years, it's become a race to the bottom, leading these firms to send jobs to India in hopes of preserving margins. Pricing pressures continue, so margins in this niche are now being compressed.

The fact that IBM now has more employees in India than in the U.S. highlights just how commoditized the company's core revenue base has become. (And as a resident of New York's Hudson Valley, I lament the fact that Big Blue is a shadow of its former self in terms of white-collar employment.)

4. Don't fool investors.

IBM has increasingly come to rely on financial gimmickry to produce bottom-line results. For example, in the the third-quarter, the company posted a lower-than-expected tax rate to beat the $3.96 EPS consensus by a few cents. If the company used the tax rate that analysts were told to use 90 days ago, IBM would have missed EPS by a considerable amount.

Unfortunately, IBM has become notorious for financial sleights of hand, and savvy investors should see right through it. For example, the company's goal of $20 in EPS comes with a huge caveat. Free cash flow might not be nearly as robust, and that's the most important metric that investors should be tracking. In the third quarter, for example, IBM's cash conversion rate was just 67%, which means that free cash flow badly trailed net income.

5. Don't patent, deliver.

The biggest problem with IBM -- and one that has been around since long before Rometty took the reins -- is that it has continually frittered away its basis of innovation. IBM's engineers routinely help the company to earn more patents than any company on earth. And management then routinely lets that base of intellectual property (IP) go unused.

Here's an example: IBM was a pioneer in the field of rapid prototyping, developing machines back in the 1980s that could convert digital blueprints into actual three-dimensional products. A young engineer named Scott Crump realized that IBM had no plans to commercialize the technology, and bought the IP for pennies on the dollars IBM had invested.

Today, Crump oversees Stratasys (Nasdaq: SSYS), a $4 billion leader in the fast-growing field of rapid prototyping. There are many other companies that eventually profited from the great work done by IBM's engineers. The challenge is for IBM to take the work of its own engineers more seriously and again become a home of innovative products -- and not just patent applications.

So after watching IBM, Dell and HP spit the bit, should you conclude that investing in large tech companies is a bad idea? After all, a number of hot tech IPOs this year are garnering lush valuations from excited investors. But that's more a function of the stock market in 2013, and not all of these young companies will live up to their expectations. The short answer: You can't simply write off the large tech names.

Take Cisco Systems (Nasdaq: CSCO) as an example. The network equipment giant has also posted anemic revenue growth in recent years, and like IBM, has been able to generate EPS growth only through massive share buybacks. But unlike IBM, Cisco continues to push for industry-leading innovation in all of its tech niches, and it looks very well-positioned to boost sales when its core end-markets start to grow. The distinction in these two companies' technology visions explains why one company is a bargain and the other is a value trap.

Risks to Consider: As an upside risk, IBM could break itself into smaller, nimbler divisions, which would quickly be embraced by investors

Action to Take --> Though IBM has an increasingly bleak future -- unless it embarks upon a radical change -- it remains as one of the most profitable companies (on an absolute basis) on the planet. That leads investors to the question: "At what price would shares be attractive?" My view: never. IBM's massive status means the company (and its stock) will never crash, but it's just too hard to see any catalysts that would push this stock higher.

P.S. IBM is a classic blue-chip stock, and it was long one of the tech industry's most dominant companies. We recently identified more of the market's most dominant companies in our latest report, "The Top 10 Stocks Of 2014." These 10 stocks have nearly tripled the market's return, delivering an average 129.5% gain over the past five years. And that's just the beginning... To get more information -- including names and ticker symbols -- click here.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.