International Business Machines Corp. (IBM): Earnings Reveal Software Troubles

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July 22, 2015 10:51am ETF BASIC NEWS

investJim Bach: Just after the bell yesterday (Monday),International Business Machines Corp. (NYSE:IBM) earnings were released.

And the results were dismal.

So dismal, in fact, that the IBM stock price has fallen 5% in morning trading, erasing all the gains it has made in the last two weeks.

It wasn’t just that IBM earnings revealed a 13th straight quarter of declining sales. The savvier IBM observers are aware that the IBM high-value strategy revolves around shedding low-margin segments – low-end servers, chips, and customer care, for example – and growing margins.

And it’s not even that IBM earnings showed a slight miss in revenue. IBM posted sales of $20.8 billion, close to Wall Street expectations of $20.9 billion. In fact, IBM beat earnings-per-share expectations of $3.78 by $0.06.

What was so disappointing about IBM earnings was that a strong dollar and weak sales in the BRICS countries absolutely decimated IBM software sales.

When IBM Chief Financial Officer Martin Schroeter opened up yesterday’s earnings call for questions, Bernstein Research’s Toni Sacconaghi pointed out a troubling fact about software sales, which he noted dropped 3% for the quarter.

“I think other than the financial crisis in ’09, that’s the lowest software growth rate in the last 15 years,” Sacconaghi said.

It’s no wonder that following IBM earnings, the market punished the IBM stock price…

IBM Earnings Reveal Software Troubles

There’s a certain amount of flailing sales IBM investors are willing to stomach. It’s been said many times before by Chief Executive Officer Virginia “Ginni” Rometty and in several conversations Money Morning has had with IBM management.

Right now IBM is in transition. It’s a painful one, but it’s necessary if IBM wants to stay relevant in an enterprise tech landscape that’s largely migrating to the cloud.

IBM will likely not post another $100 billion year like it did as recently as 2012. But at the same time, many of IBM’s Fortune 100 clients are going to stick with IBM to migrate systems and applications to cloud. And that will be a huge revenue generator.

That’s the IBM cloud strategy. Critics will deem IBM’s cloud pursuits fruitless as Inc. (Nasdaq: AMZN) and Google Inc. (Nasdaq: GOOG, GOOGL) – two companies who care very little about margins on their cloud ventures – are fighting a price war that’s effectively commoditized cloud.

But Amazon and Google are fighting a price war for Infrastructure-as-a-Service (IaaS), the component of cloud that encompasses virtual data centers. Even as IaaS becomes a commodity, and even with IBM offering an IaaS platform with SoftLayer, IaaS is not a part of IBM’s long-term cloud strategy.

IBM’s high-value cloud strategy is primarily focused on not only helping its already impressive list of Fortune 100 clientele to migrate to cloud, but also on building value in the Platform-as-a-Service (PaaS) cloud market. Through PaaS, IBM is essentially helping app developers build business applications in the cloud.

So while a startup simply looking for a solution will go to Amazon, a big bank looking to create a mobile banking app, for example, will go to IBM. And IBM can help them transform their applications and systems to incorporate new technology.

But there’s one problem with IBM stock following IBM earnings…

Why Q2 2015 IBM Earnings Are So Telling

IBM will likely be able to excel in its niche in cloud. In the last 12 months, it’s helped IBM net more than $8 billion in sales. And what’s more, IBM has built its analytics segment – primarily through its Watson systems – into a $17 billion business.

All of this growth in these strategic initiatives is good for IBM stock in the long run, but right now, the markets aren’t too concerned. The markets are digesting IBM earnings and looking at the troubling developments in software and middleware sales and punishing IBM stock.

This is a valid reaction. After all, in what has turned into a painful transition, investors are worried that IBM’s promising growth initiatives aren’t growing fast enough to stave off the losses in its legacy businesses.

Obviously IBM can stomach some hits to its hardware segments – it has divested its low-end servers and chips. Hardware has actually been a net negative to the bottom line, making up negative 0.7% of total income  since Rometty stepped in as CEO in Q1 2012.

But software and middleware is the most high-value segment in the IBM portfolio. Its high margins have contributed roughly 45% to 50% of IBM’s bottom line since 2012.

So when sales in this division take a hit, it’s going to make investors nervous. And that reveals something very telling about IBM stock.

It’s not a buy right now.

You can believe in IBM’s strategy. You can also ignore a lot of the overblown statements about IBM’s best days being behind it. But the market can’t.

Until IBM’s strategic initiatives deliver solid IBM earnings growth, IBM stock is going to be volatile.

And for a company as big as IBM, it’s hard to recommend a stock that can so easily fall 5% on earnings.

If you want to buy IBM stock, wait for one final capitulation. If you can get it at a time when the markets sour on it and it falls to between $145 to $150 a share, then you’ll want to buy and hold.

The Bottom Line: This IBM earnings report showed that the market is still maintaining a close eye on IBM’s legacy business segments, even as the company finds success in its strategic growth initiatives. The market remains sensitive to any disruption, and this has led to IBM stock price volatility. If you want to buy IBM stock, you’re better off waiting for these growth initiatives to flourish or for the market to oversell. Either way, right now is not the best time to buy, unless you’re willing to stomach wild price fluctuations for a while.

Money MorningWritten By Jim Bach From Money Morning

We’re in the midst of the greatest investing boom in almost 60 years. And rest assured – this boom is not about to end anytime soon. You see, the flattening of the world continues to spawn new markets worth trillions of dollars; new customers that measure in the billions; an insatiable global demand for basic resources that’s growing exponentially; and a technological revolution even in the most distant markets on the planet.And Money Morning is here to help investors profit handsomely on this seismic shift in the global economy. In fact, we believe this is where the only real fortunes will be made in the months and years to come.

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