Why You Shouldn't Overreact to IBM's Earnings

IBM is struggling through its turnaround, but long-term investors will be rewarded for their patience.

Jan 25, 2014 at 3:00PM

Investors were hoping for signs of a quick turnaround when International Business Machines (NYSE:IBM) reported its fourth quarter and fiscal 2013 results. Unfortunately, IBM's progress is slower than the market would like. IBM's fourth quarter continued its trend from recent quarters of earnings growth against declining revenue.

From the market's perspective, cost cuts and share buybacks to engineer profit growth aren't good enough. While it's understandable to be disappointed over IBM's lackluster revenue performance in 2013, it should be given time to get its business back on track. IBM is a huge company, and turnarounds of this nature don't happen overnight. That's why Foolish investors would be wise to not overreact to IBM's disappointing earnings report.

IBM: A company in transition
The market was clearly displeased with IBM's report as well as its outlook, since the company's shares fell 3% after it released results. To be sure, there were enough disappointing items to complain about. Investors count on IBM for top-line growth due to its status as a world-class blue chip, but the company is stumbling in one key area.

For many years, IBM was known as a hardware company. Over the past few years, however, management decided to take the company in a new direction—and rightfully so. IBM deserves credit for seeing the writing on the wall in the technology world. Hardware is a shrinking business; going forward, growth will be most pronounced in software and services, particularly in cloud-based solutions.

IBM has transitioned itself to become much more of a technology consulting business, which has been a wise decision. This is what separates IBM from Hewlett-Packard (NYSE:HPQ), which has, for the most part, remained stuck in the hardware industry. All of HP's seven core operating segments saw revenue decline in the most recent year, led by its personal systems and printing group. Those segments produced a double-digit revenue decline.

Not surprisingly, hardware continued to be the sore-spot for IBM as it has for much of the past several quarters. In the fourth quarter, hardware revenue collapsed 26%. Fortunately, IBM's hardware business accounts for a relatively modest portion of its total revenue base. Nevertheless, the damage in the fourth quarter more than offset relatively decent results in the company's two larger segments, software and services. This is why total revenue fell 5% in 2013.

A $200 billion company doesn't turn on a dime
Large-cap technology giants simply can't turn their businesses around in a matter of a few quarters. Notice the changes being attempted at Oracle (NYSE:ORCL), which is in the middle of a similar shift to cloud-based solutions and services. Revenue from new software licenses and cloud software subscriptions in its most recent fiscal quarter ended November 30 was flat year over year. In addition, revenue from hardware systems products fell 3% in the same period. Total revenue inched up 2%, so it's clear that these types of transitions take time.

IBM is a $200 billion company by market capitalization, so its own turnaround will likely take more time. The market seemed disappointed with its fiscal 2014 projections, even though IBM expects to earn adjusted earnings of at least $18.00 per share. This would actually represent 10% earnings growth, and IBM remains fully committed to its promise to earn $20 per share in operating earnings by 2015.

IBM still generates a lot of free cash, which it will reinvest in the most promising growth areas going forward. Revenue growth may not materialize in the near term, but the company will still produce earnings growth from using some of its prodigious cash flow to buy back stock. In the meantime, investors can snatch up IBM for just 10 times forward earnings, with a 2% dividend yield as a nice bonus. That's why long-term investors would be wise to be patient with IBM.

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Bob Ciura has no position in any stocks mentioned. The Motley Fool owns shares of International Business Machines and Oracle.. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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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