An Important Update On Big Blue's Turnaround

Nathan Slaughter's picture

Tuesday, November 5, 2019 - 2:30pm

by Nathan Slaughter

There's some much-needed good news to report for shareholders of one of America's most storied companies.

IBM logoShortly after sealing the $34 billion acquisition of Red Hat back in July, IBM (NYSE: IBM) predicted the open-source software provider would generate $350 million in revenues in its first full post-merger quarter. The actual number: $371 million.

That contribution helped third-quarter revenues from Big Blue's cloud and cognitive software unit rise 6.4% to $5.3 billion. 

That's the good news. For those who may not be familiar, the Red Hat acquisition is one of a number of moves Big Blue has made in recent years to remake itself. 

The bad news: Unfortunately, it wasn't enough to offset weakness elsewhere, most notably in the core global technology services division. 

Can Big Blue Finally Turn It Around?

Overall sales for the period dipped 4% to $18 billion. That was about $200 million below expectations -- and the fifth consecutive quarterly decline.

On the positive side, adjusted earnings of $2.68 per share came in ahead of expectations for the 9th straight quarter. But the investment community remains fixated on the persistent top-line slump. This has dogged IBM as the company transitions from legacy mainframe computer servers into cloud services, cybersecurity, artificial intelligence, and other 21st-century arenas.

In fairness, the revenue picture last quarter was muddied by divestitures and foreign currency translation. And Red Hat is certainly moving the needle, with revenue growth accelerating to 19% from 15% the prior quarter. But the rest of the business looks lackluster, which is why several analysts have pared back their price targets recently.

IBM shares have retreated from $143 last issue to a recent close near $137, giving back some of their 25% year-to-date gain.

IBM ytd chart

Short-term investors might find this a good time to cash out and walk away. Admittedly, I gave some thought to it myself. But as I recently told my Daily Paycheck premium subscribers, pulling the plug here and booking our gains might be a bit premature. Companies this size don't turn on a dime, and I am willing to give management more time to execute on their turnaround plans.

It's easier to be patient knowing we are pulling in a dividend yield of 4.8%. And next year, the company will become a Dividend Aristocrat -- joining the exclusive list of companies that have raised payouts for 25 straight years or more. 

And there are numerous bright spots with the business, too. Among others, IBM just landed a multi-year partnership deal with AT&T (NYSE: T) that will see the two companies collaborate on new technology platforms in the 5G era. The telecom giant has agreed to make IBM the preferred provider of cloud services for its enterprise customers.

Meanwhile, IBM still has its colossal patent portfolio, research labs, the world-famous Watson super-computer and cognitive platform, and an urgent focus on evolving for the future.

Action to Take 

There is softness across key business lines, and the jury still out on how long it will take Red Hat to push overall revenues meaningfully forward. On the other hand, IBM has chalked up $20 billion in cloud-related revenues over the past 12 months alone. 

IBM has also taken great strides to improve its balance sheet, eliminating nearly $7 billion in debt over the past three months alone. It has also reaffirmed forecasts to generate $12 billion in free cash flow this  year -- more than 100% of reported GAAP net income.

With that said, I think it's prudent to cautiously consider IBM a "buy". This dip may prove to be a good entry point for investors who haven't already bought shares.

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Nathan Slaughter 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.