On Oct. 20, IBM (IBM +0.54%) handed in a dud of an earnings report. The company badly missed analyst estimates on both the top and bottom lines, and the stock crashed 8% immediately after the quarterly numbers were released.
If there's a silver lining, it's that IBM is continuing the painful yet necessary step of divesting its hardware business. Although that is weighing on IBM today, these moves will pave the way for a brighter future. Here's what investors searching for value in IBM shares need to know now.
IBM's horrible quarter
IBM posted an operating profit of $3.68 per share on revenue of $22.4 billion in the most recent quarter. This came in well short of expectations for $23.37 billion in revenue and $4.31 per share of operating earnings. Management attributed the weak results to poor client orders in September.
At the same time, IBM continued to see progress in its core strategic initiatives. In short, the scourge of underperforming hardware businesses continued. IBM announced it would shed its semiconductor business to chipmaker GlobalFoundries. What's amazing about this deal is that IBM is actually paying GlobalFoundries $1.5 billion to take the money-losing semiconductor business off its hands.This says a lot about where IBM is in hardware. That being said, this is what IBM must do as it moves forward with its years-old turnaround efforts.
IBM has conducted a number of deals in recent years to divest itself of technology hardware. Investors might recall that earlier this year the company sold its x86 server business to Lenovo (LNVGY +2.30%) for $2.1 billion.
These deals will help the company focus on other areas outside hardware, such as data analytics and services, which have actually been working in IBM's favor. This is especially true for IBM's cloud-based offerings, where revenue was up more than 50% through the first three fiscal quarters. For cloud delivered as a service, revenue soared 80% to reach a $3.1 billion annual run rate. Other pockets of strength included business analytics, in which revenue increased 8% through the first three quarters, year over year.
However, IBM made a significant change in its financial outlook that severely damages the company's visibility regarding future earnings, and makes investing in IBM based on valuation a very uncertain proposition.
IBM ditches its $20 EPS plan
Along with its earnings report, IBM revealed it could no longer keep its long-given promise to earn $20 per share in operating profit in 2015. This had been a linchpin of IBM's value proposition for investors during its poor performance over the past year.
That pledge had given value investors reason to buy the stock, based on IBM's conservative valuation. At $170 per share, IBM is valued at just 8.5 times forward earnings. This is about half the forward-looking valuation of the broader stock market, which makes IBM look very cheap.
Unfortunately, abandoning that forecast calls IBM's valuation prospects into question. This helps explain why the stock continued to sell off the day after earnings, even while the Dow Jones Industrial Average soared 200 points. Investors buying in at these levels don't have nearly the same confidence in IBM's turnaround prospects.
IBM will release a fresh 2015 outlook in January. The company said it expects full-year 2014 operating EPS to be down 2% to 4% off the previous year's comparable base of $16.64. While IBM stock still looks cheap, part of the valuation case depends on what earnings are going to look like next year. Investors need to pay close attention in the event IBM's new forecast comes in drastically below $20 in earnings per share.
