2014 is shaping up to be another strong year for stocks. Thanks to the recent rally, the Dow Jones Industrial Average has tacked on 7% this year after a 27% jump in 2013. But it seems like someone forgot to tell IBM (IBM 3.07%) the bull market is still in full swing. Shares of the blue chip tech giant have dipped 14% this year making it the worst-performing stock on the Dow.
So, what's going on with Big Blue? The troubled started, in large part, thanks to a sharp sell-off following a dismal third-quarter earnings report. IBM reported adjusted earnings of $3.68, well short of estimates which averaged $4.32. In its quarterly release, the tech giant noted, "A marked slowdown in September in client buying behavior, and our results also point to the unprecedented pace of change in our industry." That weak performance prompted management to jettison its long-held target of $20 in earnings per share in 2015.
The poor results were due, at least in part, to the fact that IBM is in the midst of a transition, selling off lower-margin legacy divisions in order to focus on higher-margin growth areas such as cloud computing, business analytics, mobile, and security, amid the the fast pace of change in the industry that's been made the scapegoat for the company's disappointing financial results. However, the stock's under-performance is nothing new. Over the last three years, the Dow has risen 47% while IBM has lost 15%.
So what's killing Big Blue?
After a strong 2011, IBM declared itself well on its way to exceeding its goal of $20 in earnings per share in its annual report that year. It also outlined four "high-growth spaces that should drive approximately $20 billion in revenue growth by 2014." Those areas were: Growth Markets, Business Analytics, Cloud, and Smarter Planet.
Fast forward to 2014 and it's clear that these segments are hardly a growth engine for the company. In the third quarter, revenue from growth markets fell 5% after adjusting for currency translation. Performance in business analytics was better, but is only up 8% year-to-date. The quarterly report no longer makes reference to the "Smarter Planet" initiative, making that comparison impossible, which leaves cloud computing as the only component still delivering significant growth, having increased by 50% year-to-date, but cloud is increasingly a low-margin, highly competitive business.
Though IBM claimed that those growth areas would spark $20 billion revenue growth between 2011 and 2015, revenue has instead fallen by about $9 billion or 9%, in that time as the chart below shows.
IBM Revenue (TTM) data by YCharts
Where's all the money going?
The $20 EPS goal for 2015 wasn't just predicated on sales growth. IBM has been implementing a massive share buyback program that has reduced share count from 1.16 billion at the end of 2011 to 990 million today, accounting for over $30 billion in repurchases.
The buyback program is nothing new for IBM. In the five years leading up to 2011, the company repurchased $50 billion worth of shares, which helped the stock nearly double in that period. The difference then was that IBM was still a growing company. As the chart below shows, revenue increased at a solid pace during those five years with the exception of a dip during the recession.
IBM Revenue (TTM) data by YCharts
Despite IBM's woes over the last three years, it has not increased spending on Research & Development to boost its growth endeavors, and it has actually spent more on dividends and share buybacks than it has brought in in free cash flow. Last year, expenditures on dividends and buybacks nearly equaled operating cash flow. At the same time, its debt burden has jumped $10 billion to help fund the rampant buybacks.
But buybacks are a luxury, not a necessity, and for a company to be spending so much on them, especially a technology company, seems to signal an unwillingness to invest in itself and its opportunities, which are necessary for growth. Share buybacks can be useful if shares are undervalued and the underlying business is strong, but for a weak business it does nothing to improve competitiveness. It's the laziest way to spend profits.
IBM is not without its defenders of course. Chief among them is Warren Buffett, whose Berkshire Hathaway owns 7% of the company. Though Buffett has eschewed investments in tech companies throughout his career, he bought IBM, starting in 2011, in part because its management had a pattern of declaring long-term goals and then methodically delivering on those promises.
The problem with that argument though is that IBM is not Coca-Cola. It's not the same company it was 10 or 20 years ago, and it can't be expected to deliver a repeat performance. Its CEO, Ginny Rometty, has been at the helm just three years, and the company competes in a rapidly changing industry, which has forced it to reinvent itself several times in its history, including now.
And its habit of setting those long-term goals is actually what got the company into trouble in the first place. IBM indeed set a goal for 2015, at $20 EPS, but instead of growing its business to try to meet that goal, it instead took a short cut with buybacks. Now, it finds itself in a much weaker competitive position, and with declining revenue and profits.
Perhaps Buffett should have followed his own earlier advice on tech stocks. Back in 1996, during the tech boom, he told Berkshire investors, "We are searching for operations that we believe are virtually certain to possess enormous competitive strength ten or twenty years from now. A fast-changing industry environment may offer the chance for huge wins, but it precludes the certainty we seek."
These days, the only thing certain at IBM seems to be more buybacks.
