Is It Time to Give Up on International Business Machines (IBM)?

Shares of IBM (IBM 0.06%) slid nearly 5% during after-hours trading on Oct. 16 after the tech giant posted a mixed third quarter report. Its revenue fell 2% annually to $18.8 billion, missing estimates by $330 million and breaking its two-quarter streak of revenue growth. On a constant currency basis its revenue stayed flat year-over-year.

On the bottom line, IBM's non-GAAP net income rose 3% to $3.1 billion, and its EPS rose 5% to $3.42, beating estimates by two cents. On a GAAP basis, IBM's net income fell 1% to $2.7 billion, and its EPS grew just 1% to $2.94.

Image source: Getty Images.

Those numbers likely disappointed investors, who were expecting Big Blue to maintain its positive growth. But is it time to finally give up on this sluggish stock, which shed about a quarter of its value over the past five years?

What went wrong for IBM

IBM's turnaround hinges on its ability to keep growing its "strategic imperatives" (cloud, analytics, mobile, social, and security) businesses to offset the weakness of its legacy (IT services, enterprise hardware, and software) businesses.

IBM's strategic imperatives revenues rose 13% annually (11% on a constant currency basis) to $39.5 billion over the past 12 months, accounting for nearly half of its total revenue. That growth sounds solid, but it also represents a slowdown from its 15% growth (12% on a constant currency basis) during the second quarter.

IBM's strategic imperatives aren't reported as a separate business segment. Instead, they're scattered across Big Blue's multiple business units. Most of those units fared poorly during the quarter, as the weakness of older products and services offset the growth of its strategic imperatives:

Source: IBM Q3 report. *Constant currency basis.

The most disappointing numbers

IBM's 5% decline in Cognitive Solutions revenue was extremely disappointing since the unit houses its Watson AI platform and analytics tools. IBM previously claimed that Watson's ability to apply machine learning to massive amounts of data would revolutionize a wide range of industries, including the healthcare, cybersecurity, education, and financial markets.

However, Watson's results haven't impressed industry experts, who generally think that Watson is an overhyped platform built on marketing gimmicks and old technologies. Oren Etzioni, CEO of the Allen Institute of AI, told Gizmodo that IBM makes "outlandish claims that aren't backed by credible data," while Social Capital CEO Chamath Palihapitiya called Watson "a joke" during a CNBC interview last year.

Meanwhile, IBM's Cognitive Solutions business faces tough competition from similar analytics platforms from Amazon's (AMZN -2.56%) Amazon Web Services and Microsoft's (MSFT -1.27%) Azure, which both have much larger public cloud platforms than IBM.

Image source: Getty Images.

That's why IBM's flat growth in Technology Services & Cloud Platforms revenues looks downright ugly. IBM reported that it finished the quarter with an annual run rate of $11.4 billion for its cloud services, which represented 24% growth on a constant currency basis.

However, Microsoft's commercial cloud revenues grew 53% annually to $6.9 billion last quarter, while Amazon's AWS revenues jumped 49% to $6.1 billion. On an annualized basis, both companies are generating more than twice as much revenue from cloud services as IBM. Those are the "big strong competitors" Warren Buffett referred to on CNBC prior to selling all of his IBM stock earlier this year.

During the second quarter IBM managed to offset some of the weakness in its other businesses with a 23% jump (on a constant currency basis) in Systems revenue. But during the third quarter the unit's growth rate hit a brick wall, posting just 2% growth. That big drop was likely caused by soft demand for its z14 servers, which launched a year ago.

On the bright side, IBM's gross margin held steady year-over-year at 46.9% as higher margins at Global Business Services, Technology Services & Cloud Platforms, and Global Financing offset declining margins at Cognitive Solutions and Systems. Its guidance for the full year also wasn't terrible -- it still expects its non-GAAP EPS to advance "at least" 1% to $13.80, and it expects to generate about $12 billion in free cash flow. This means that it can easily cover its forward yield of 4.5% for the foreseeable future.

So is it time to give up on IBM?

IBM's stock looks cheap at about 10 times this year's earnings, and it's still a decent income stock. Unfortunately, the company simply lacks any meaningful catalysts, and faces far too many long-term headwinds. Until IBM gets its act together, I'd rather stick with other "mature tech" stocks with better growth potential.