International Business Machines Corporation (NYSE:IBM) is one of the most interesting propositions in the technology sector. The company is seeing ongoing deterioration in revenue. However, in common with its rival, Oracle Corporation (NYSE:ORCL), it still generates large amounts of free cash flow, and it's making aggressive investments in its growth platforms. Moreover, Oracle and IBM are both making partnerships -- witness IBM's recent deal with Apple (NASDAQ:AAPL)-- in order to remain relevant in a changing IT landscape. With that said, investors are entitled to ask an existentialist question about IBM. What is it? A low-growth and highly cash-generative value play, or a company transitioning toward a becoming a long-term growth story?
IBM raises more questions than answers
First things first, IBM is not an expensive stock. The company trades on 13.3 times current earnings and less than 11 times the company's projection for non-GAAP EPS for 2014. For some value investors, that's pretty much all they need to know. Throw in the 2.4% dividend yield, and the targeted $16 billion in free cash flow for the year and it's seemingly a no-brainer.
Unfortunately, investing isn't as easy as that, and there are plenty of questions being asked about the company's plans. A chart of its segmental revenue growth reveals the extent of the revenue decline in recent years. Global technology services hasn't recorded positive year-over-year growth since the first quarter of 2012, and Global business services has only generated two quarters of (paltry) growth since the end of 2011.
If its core business keeps declining, it won't be a value play anymore, and the pressure is intensifying for IBM to wring every bit of margin expansion it can out of falling revenue. Indeed, in its latest second-quarter results, IBM managed to generate a 10 basis point improvement in its non-GAAP gross margin, but because total revenue declined 2.2%, its non-GAAP gross profit fell by 2 percentage points.
Why IBM isn't Oracle
In some ways, it's easy to compare IBM with Oracle. Both are mature highly cash-generative companies with slowing or declining revenue growth, and both are investing in growth platforms. However, the difference is that much of what Oracle is doing involves adjusting to how its customers want software delivery. In other words, there is a structural shift from traditional on-premise, on-license software toward cloud-based subscription delivery. Indeed, Fools already know how Oracle's revenue growth is being affected by foregoing upfront software license sales for cloud-based subscription ones.
Oracle's growth initiatives involve shifting to the cloud, and supporting this activity by investing in infrastructure as a service, or IaaS, in order to support sales of its software. This is something that a host of other leading tech names, including IBM, are already doing.
However, IBM's other growth initiatives come with more questions attached. In its latest earnings report, the company outlined that its strategic growth initiatives grew revenue in double-digits, with cloud revenue up more than 50 percent year to date, while its cloud delivered as a service increased its annual run rate by 100% to $2.8 billion year to year -- a big number, but still not significant when compared to total revenue in 2013 of nearly $100 billion. Moreover, the company outlined a number of growth investments, but many of them carry execution risk as well as uncertain end-demand prospects.
- The first-quarter launch of Bluemix, a cloud platform-as-a-service, or PaaS, for enterprises
- $1.2 billion investment in its SoftLayer clous hubs, an IaaS initiative
- $1 billion investment in its Watson supercomputer, to support IBM's big data analytics capabilities
- $3 billion investment in chip technology over the next five years, in order to support cloud and big data initiatives
- A global strategic partnership with Apple Inc, in order to develop business applications on Apple's products
While all of these initiatives are exciting, there is no guarantee IBM will win out in the IaaS or PaaS market against competitors like Oracle. Similarly, big data analytics is an obvious growth area, but IBM still has work to do to convince customers to buy future Watson solutions. As for the Apple partnership, it's somewhat dependent on Apple generating good growth of iPad sales to enterprises. Adding IBM's business software to Apple's hardware should create a value-add to Apple's products, but predicting IT hardware product trends is fraught with difficulty. Moreover, the enterprise market is not a core target market for Apple.
So, what is IBM?
All told, it's better to think of IBM as a growth company disguised as a value company. Its management is doing the right things by making divestitures and focusing on growth initiatives, but investors should not just buy into the stock on a value basis. Competition is fierce with Oracle and others, and the partnership with Apple Inc may sound exciting, but it's unlikely to meaningfully contribute to revenue anytime soon. In short, don't buy IBM just because it looks like a good value on a numbers basis alone.