International Business Machines (NYSE:IBM) is a company in transition. Formerly known as a leader in the technology hardware space, IBM is trying desperately to shift focus into software and services. Fortunately, several years ago, management saw the writing on the wall -- which is that hardware is not the future of technology.
The unfortunate part is that the turnaround is taking longer than management likely anticipated. That's because companies the size of IBM can't simply turn on a dime. It's a $188 billion company by market capitalization, after all. A meaningful turnaround for a company this large will take time.
The same thing is happening to Hewlett-Packard Company (NYSE:HPQ). It's also trying to break away from hardware and enter newer technologies, but progress has been slow.
IBM management has pledged to produce $20 per share in operating profits by the end of next year. That would represent a fairly big jump from its profits last year. Since its refocusing is taking longer than expected, you might think IBM is setting itself up for disappointment. But there's actually reason to believe that IBM can hit its forecast. Here's how it will do it.
Can earnings grow with poor revenue growth?
In short, yes. IBM's revenue growth in recent periods is unimpressive. Revenue fell 5% last year, then declined another 4% in the first quarter of 2014. That hardly sounds like a recipe for producing strong earnings growth. Indeed, IBM's target of $20 in operating EPS represents 22% growth from the $16.28 per share generated last year.
Many of IBM's problems have to do with hardware. Revenue in the systems and technology group fell 23% last quarter. Meanwhile, other non-hardware-related segments are performing relatively well. IBM is growing nicely in middleware. Revenue from WebSphere grew 12%, while revenue from Tivoli software increased 7%.
IBM is doing even greater things in cloud solutions. Cloud revenue jumped 50% last quarter. And, for cloud delivered as a service, the company reached an annual run rate of $2.3 billion, which doubled year over year.
Likewise, HP's core business continues to be centered on hardware, which is really holding it back. It's busily building out its other software and services businesses, but its large printers segment continues to drag it down. HP's revenue fell 7% in 2013, and the company followed this performance with a 1% revenue decline in the fiscal 2014 first quarter.
On the second-quarter conference call, HP Chief Executive Meg Whitman assured analysts that sustained revenue growth is her top priority. To accomplish this, she pointed to several initiatives in new areas that will fuel the future.
Not surprisingly, HP is gearing significant investment toward the cloud, just like its technology peers. For example, HP launched a new portfolio of products and services called Helion, which allows for seamless and secure integration of private, public, and managed cloud information at the enterprise level.
In similar fashion, IBM is shifting its hardware business toward higher-value opportunities. In particular, it's growing its systems product portfolio, more specifically in power and storage, in an attempt to build on its strength in big data and mainframes.
The formula for $20 EPS
In the meantime, IBM already has a highly profitable business that throws off a lot of cash. This is then funneled back to boost earnings growth through huge share repurchases. IBM has repurchased $108 billion of its own shares since 2000. This includes $13.9 billion in share buybacks just last year.
These share buybacks are going a long way in generating earnings growth, even while revenue lags. And, when combined with cost cuts, IBM maintains its forecast to earn $20 in operating EPS by the end of next year. The forecast for the current year is $18 in EPS, so management can instill a lot of confidence in investors by reaching its near-term goal. If everything goes according to plan, IBM can definitely reach its ambitious profit expectations.