As IBM Hits a Wall in Emerging Markets, Investors Need to Exercise Patience

It seems that the bad news out of China keeps piling up for IBM.

Jul 1, 2014 at 6:00PM

Over the past year, International Business Machines (NYSE:IBM) has tried diligently to improve its business standing in emerging markets. Despite its efforts, IBM just can't get its act together in developing economies such as Brazil, Russia, India, and China, otherwise known as the BRIC nations.

IBM's revenue has fallen for several quarters in the BRIC nations, and the situation is especially difficult in China. Things are getting even more difficult there, on the news that Chinese companies in a variety of industries are ditching U.S.-based technology suppliers in favor of domestic competitors. The ripple effects are spreading, and now IBM's $2.3 billion sale of its server business to Lenovo Group Limited (NASDAQOTH:LNVGY) is in doubt.

IBM management has pledged to earn $20 per share in core operating profits by 2015. That would represent approximately 23% earnings growth over the company's 2013 operating profits per share. But with economic growth still restrained in developed markets like the United States and Europe, it's unlikely IBM will be able to reach its goal without the help of emerging markets.

Under-developed economies represent a great opportunity for technology companies, and IBM will need a meaningful contribution from emerging markets in order to hit its target by the end of next year.

IBM is missing the party
While companies across other industries plant their flags in emerging markets and realize strong growth from developing nations, IBM is missing out. Revenue in the BRIC nations fell 11% in the first quarter. To be fair, this did represent an improvement from the previous quarter. IBM's revenue fell 14% in the BRIC nations in the fourth quarter of 2013. Nevertheless, it's hard to get too excited about a company that is routinely posting double-digit revenue declines in a key geographic region.

In all, IBM posted 4% lower revenue and 15% lower adjusted operating EPS last quarter. This was only slightly better performance than last year, in which IBM's revenue fell 5%. IBM has now posted revenue declines in eight consecutive quarters. IBM's emerging markets are under-performing its other geographic regions. This is surely a disappointing performance, since IBM was counting on emerging markets, and China more specifically, as a key source of growth.

Things probably won't get much easier considering the recent stance taken by many Chinese companies. Because of a desire to opt for cheaper, Chinese companies in industries ranging from e-commerce to banks are granting contracts to local suppliers at an increasing rate.

Making matters cloudier are the growing national security concerns brought forth by the U.S. government regarding IBM's potential asset sale to Lenovo. IBM had long wanted to divest its low-end server business to Lenovo for $2.3 billion. This was a key strategic initiative for IBM, which is now in doubt, because of concerns that the servers sold could be compromised in some way, according to a report from The Wall Street Journal.

The situation in China is bad, and it's not expected to improve any time soon. Revenue in China fell 20% last quarter, and IBM management admitted in its first-quarter conference call that it will take some time for the continued weakness to reverse. That's because the challenges there are cyclical in nature, and improvement is still a ways away. In the meantime, though, IBM is committed to investing in the region, signaling management's belief in the long-term trajectory of Chinese growth.

Be patient with IBM
To be sure, IBM is a highly profitable company that generates a lot of free cash flow. In turn, the company heaps billions of dollars on investors through share repurchases and dividend payments. However, you will need to exercise a lot of patience with IBM.

IBM is still declining in China, and it's going to take time for it to get its act together. The pervasive distrust between the U.S. and China only complicate matters, and it's throwing a wrench in one of IBM's strategic initiatives. As a result, you shouldn't expect IBM to return to growth in China for at least a few more quarters.

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Bob Ciura has no position in any stocks mentioned. The Motley Fool owns shares of International Business Machines. 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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