Being a global technology company operating in more than 170 countries, International Business Machines (IBM -0.89%) is no stranger to risk. Currency fluctuations, which hurt IBM's results in 2015, are an ever-present risk factor, particularly because IBM derives the majority of its revenue from international markets. Another risk: The potential policies of the incoming Trump administration could roil relations with countries like China, where IBM has a major presence.
Image source: IBM.
All of this matters for IBM investors. But the biggest risk, one that could have an outsize effect on the stock price going forward, is the possibility that IBM's ongoing transformation fails to reignite growth. The company's growth businesses, what it calls strategic imperatives, now account for around 40% of total revenue while still growing at a double-digit pace. Meanwhile, legacy businesses are shrinking. The net result over the past few years has been a decline in both revenue and earnings.
The expectation of IBM investors is that this new revenue will be at least as profitable as the old revenue that's disappearing, thus eventually driving earnings higher when revenue begins to grow again. There are plenty of reasons to believe that this will be the case. But IBM has yet to return to earnings growth, and until it does, there will be a lingering uncertainty around its transformation.
Years of decline
IBM expects to produce at least $13.50 per share in adjusted earnings this year, down from $14.92 in 2015 and $16.53 in 2014. Revenue has been declining, driving a portion of the earnings decline, but currency has also played a significant role.
The rapid growth of IBM's strategic imperatives has yet to balance out declines in other businesses. Cloud revenue over the past 12 months was $12.7 billion, with cloud as-a-service reaching an annual run rate of $7.5 billion at the end of the third quarter, up 65% year over year. Strategic imperatives in total produced $8 billion of revenue during the third quarter alone, up 15% year over year.
Despite this growth, total revenue was flat during the third quarter. Part of the problem was hardware -- IBM's mainframe revenue was down substantially, a normal occurrence for where the product is in the cycle. But the bigger problem is that these growth businesses are still not big enough to drive growth for the company.
Once they do become big enough to drive revenue growth, the question will be whether earnings growth returns. Is IBM's cloud business going to be profitable enough to offset declines in hardware sales? Will moving to a subscription software model produce as much profit as selling software licenses? There's a chance that IBM ends up being structurally less profitable than it has been in the past. That's the biggest risk facing investors.
Reasons to be optimistic
The good news for IBM investors is that the company's strategy involves going after areas where it can build a competitive advantage. IBM's cloud strategy is to focus on enterprise customers and hybrid cloud, instead of trying to compete on cost in the infrastructure-as-a-service market. IBM will never out-Amazon Amazon, but it can provide high-value cloud solutions to its customers, including services like Watson, the company's cognitive computing system.
Image source: IBM.
IBM has one major advantage -- its existing customer base -- that shouldn't be overlooked. The company counts as customers 90% of the world's top 100 banks, 80% of the top 50 global retailers, more than 200 state and local governments, nine of the top 10 global telecom companies, and 49 of the top 50 healthcare organizations in the U.S. This large, sticky customer base increases the odds of a successful transformation for IBM and decreases the odds that the company ends up in a perpetual state of decline.
IBM has yet to prove that its transformation will be successful. The company has a long track record of reinventing itself, and its massive customer base and global reach give it an important advantage. But there's certainly a chance that things go wrong. As an IBM shareholder, I think this risk is small enough to warrant investing in the stock. But it's always in the back of my mind.
