Based on the negative reaction following IBM's (NYSE:IBM) third-quarter earnings report, there's still some work to do before investors buy into its transformation efforts. Down over 3% shortly after sharing its quarterly results, IBM stock is still trying to find its way back to pre-earnings levels.
The lackluster response to last quarter is a bit surprising since IBM handily beat pundits' expectations. The consensus estimates were for $3.23 in per-share earnings on a non-GAAP (excluding one-time items) basis, and $19 billion in revenue. IBM delivered $19.2 billion in sales and earnings per share (EPS) of $3.29. Clearly, the Street still doesn't get the "new" IBM, but there are a few things worthy of investors' consideration.
What really matters
When CEO Ginni Rometty shared her "strategic imperatives" initiative two years ago, combined sales from IBM's cognitive computing, cloud, the Internet of Things (IoT), mobile, and data security totaled 22% of revenue. The objective was to increase that total to an annual run-rate of 40% by 2018. Fast-forward to IBM's recent quarter, and its strategic imperatives mission is already accomplished.
Over the past 12 months, the areas driving IBM's future generated a whopping $31.8 billion, good for exactly 40% of revenue. Each of IBM's key growth drivers enjoyed double-digit revenue gains. Better still, quarterly strategic imperatives sales climbed 16% year over year to $8 billion, equal to 42% of revenue. That's a strong signal that strategic imperatives growth as measured by a percentage of sales will continue.
Part of the reason for its $12.7 billion in annual cloud sales, which puts IBM alongside Microsoft (NASDAQ:MSFT) and its "more than $13 billion" as an industry leader, is how the two behemoths have approached the burgeoning cloud market. Like Microsoft, IBM recognized early on the opportunity lies in the data, not commoditized data hosting. IBM's entire suite of strategic imperatives are delivered via the cloud, just as Microsoft is driving its Office 365, Dynamics CRM, and related software sales.
GAAP vs non-GAAP
Some investors choose to concentrate on GAAP earnings, which include quarterly expenses, and there's certainly logic in that approach. In IBM's case, though, growth and income investors should take a hard look at its non-GAAP results, too. IBM is ahead of its stated strategic imperatives goal of a 40% annual run-rate in large part by ratcheting up research and development (R&D) spending and continuing its acquisition spree.
As per CFO Martin Schroeter, IBM has spent "more than $12 billion across capital expenditures, R&D and acquisitions so far this year." That's writing a lot of checks to be sure, and nearly half of all that money was for deals to boost IBM's strategic imperatives product suite. IBM has increased R&D spending nearly $500 million in 2016.
Not surprisingly, IBM's overhead has impacted both GAAP earnings and margins, which will likely continue for the foreseeable future. Each one of IBM's five divisions reported a decline in gross profit margin compared to the year-ago period, just as the majority of its units did in the second quarter. Overall, total gross margins eased two percentage points in IBM's third quarter, to 46.9%. Squeezed margins due to spending impacted Microsoft last quarter as well, dropping to 62% compared to 65% a year ago.
With its future clearly defined as provider of cloud-based cognitive computing, mobile, IoT, and data security solutions, to no one's surprise, IBM's systems unit revenue continues to nosedive. Last quarter's $1.6 billion in enterprise hardware and associated software revenue was a 21% drop compared to last year.
Not only should dwindling systems revenue not be a concern, it really shouldn't matter at all. Hardware defines the IBM of the past, much like PCs were Microsoft's bread and butter, not today's Big Blue. When investors begin to measure results on what matters, IBM's stock will begin to reach its appreciation potential.
Toss in a 3.7% dividend yield, and IBM becomes a long-term growth and income investor's dream stock.