Why IBM Will Still Realize Its Future Profit Potential

Despite significant weakness this year, IBM's goal of $20 earnings per share by 2015 is still within reach. Here's why.

Jan 14, 2014 at 7:00PM

It's no secret that International Business Machines (NYSE:IBM) had a rough 2013. It was one of the worst-performing members of the Dow Jones Industrial Average. IBM's share price actually declined in 2013, during a year in which the Dow had its best year in the last 18. While disappointment over IBM's lackluster performance is understandable, long-term investors understand the merits of sticking with a high-quality company undergoing a difficult transition period. That's what appears to be the case with IBM, which still has ambitious expectations for itself in the years ahead.

"Growth markets" not living up to their name
The primary culprit for IBM's declining revenue in the most recent quarter was, ironically, what it terms its growth markets. In all, revenue in this segment declined 9%. Of particular concern was performance in China, which accounted for half of the company's revenue decline. Other emerging markets saw poor performance as well. Underperformance in this segment was the principal reason why IBM missed its revenue expectations by a full $1 billion.

Poor revenue growth has afflicted a slew of major technology companies, including IBM as well as Intel (NASDAQ:INTC) and Cisco (NASDAQ:CSCO). The two, like IBM, are Dow components that had disappointing years from the perspective of underlying business performance. Intel's earnings per share are down 17% through the first nine months of the year, and management is only expecting flat results in 2014.

Meanwhile, Cisco's fiscal 2014 first-quarter earnings per share fell 5% versus the same period last year. Equally disturbing is the fact that Cisco expects current-quarter revenue to drop 4% versus the same quarter last year. Declines are expected in all of the company's major geographies.

Despite the widespread woes afflicting the large-cap technology space, IBM still maintains lofty expectations for profit growth going forward. While it may seem unlikely at the present time, the roadmap to IBM's earnings potential is still solid.

The formula for $20 EPS
Despite such notable weakness in the most recent quarter, IBM maintained both its full-year 2013 expectations as well as its long-term operational goals. Management still fully expects the company to earn $16.25 in operating earnings per share in 2013, and maintains its long-term goal of generating $20 in earnings per share by 2015. In light of the difficulties encountered this year, it's more than reasonable to wonder how exactly IBM will reach its targets.

First, IBM is in the process of a significant business shift toward higher-value, more profitable technologies. Specifically, no more will IBM be a hardware company; IBM is focusing intently on software, particularly among cloud-based offerings. IBM intends to generate half its profits from its Software operating division by 2015, and there's good reason for this. IBM increased its cloud-based revenue by 70% in the third quarter.

Next, IBM plans to aggressively repurchase its own shares with its prodigious cash flow, a long-held pattern that remains firmly intact. Despite IBM's revenue falling in the most recent quarter, its earnings per share actually increased 11%. This is due in large part to the company's share buyback program. IBM has spent $123 billion on share repurchases since 2000, which have reduced the company's share count by more than 35%. Between now and 2015, IBM plans to buy back an additional $50 billion in gross share repurchases.

In the end, trust in IBM management is the key question
At the end of the day, investors have to ask themselves whether they trust IBM management to hit the fairly ambitious goals laid out for the company. Judging by IBM's strategic initiatives, which include a major overhaul of its business focus, and tens of billions in planned share buybacks, there's a clear roadmap to reach $20 in adjusted EPS. IBM is a massively profitable business that seems to have hit a rough patch, but turning around a ship of IBM's size takes time. That's why investors would be well served to exercise patience.

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4 in 5 Americans Are Ignoring Buffett's Warning

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Jun 12, 2015 at 5:01PM

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David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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