Like most investors amid the broad market sell-off of late, IBM (NYSE:IBM) shareholders have felt the sting. Unfortunately, the stock's recent woes come following a relatively disappointing 2015 in which IBM struggled to gain both traction and investor confidence in CEO Ginni Rometty's "strategic imperatives" initiatives. IBM's transition toward new, cutting-edge markets is akin to an ocean liner making a U-turn: It takes time.
Of course, time is something many investors are loath to give, which IBM's longtime ally and sometime competitor Microsoft (NASDAQ:MSFT) knows all too well. The difference is that Microsoft's transformation efforts are slowly winning over investors, even as IBM stock meanders. And therein lies the opportunity for long-term, value-oriented growth and income investors.
What really matters
IBM's strategic imperatives include cloud-related services, cognitive computing, big data, the Internet of Things (IoT), security, and analytics via its Watson group, to name a few. In other words, IBM is looking down the road to fast-growing markets, as opposed to relying on yesterday's solutions to drive growth.
The common theme among IBM's strategic imperative business lines is data: hosting it via the cloud, comprehensive analytics, and providing customers with actionable results. If that sounds at all familiar, it's because Microsoft is also refocusing itself on many of the same markets, and its more than $8.2 billion annual cloud revenue run rate demonstrates it's a bit further down the transformation road. But then, its stock doesn't offer the same value, nor can it match IBM's nearly 4% dividend yield.
Services delivered via the cloud generated an annual run rate of $4.5 billion for IBM in the third quarter. That may not match industry-leading Microsoft, but it's impressive nonetheless. Better still, after investing billions of dollars in acquisitions and launching new units, IBM's cloud services results should continue to improve.
Thanks in large part to Watson, analytics revenue also jumped last quarter, 19% after factoring in currency. IBM doesn't share revenue specifics for its other strategic imperatives, but Rometty's objective is to generate 40% of sales from the new markets by 2018. That figure stood at 27% as of last quarter. Yes, there's a recurring theme here: IBM is investing in areas that are expected to become multibillion-dollar and -- in the cases of IoT and Big Data -- multitrillion-dollar markets.
The short-term view
Naysayers have been quick to point out last quarter's declines in IBM's traditional software, services, and hardware units , and they are right. Each of those divisions experienced a double-digit drop in Q3, and though the results may not be quite as tough to swallow when Q4 results are announced on Jan. 19, the same trend is likely to rear its ugly head.
But for the investor with some patience, concerns about results from IBM's traditional business lines should take a back seat to what really matters: its strategic imperatives. In those areas, IBM is performing admirably, and investors should see more of the same in Q4. In fact, taken as a group, results from Rometty's strategic imperatives jumped an impressive 27% last quarter, after accounting for currency headwinds.
If IBM's stock woes sound familiar, consider how long it took investors to recognize that the steady declines in Windows-related sales aren't the primary concern around Microsoft. What matters at that company is progress in CEO Satya Nadella's mobile-first, cloud-first initiatives, and in that regard, Microsoft is justifying its relatively positive stock performance. IBM is heading down a similar path, and it's one that short-sighted investors haven't bought into -- yet.
Another indicator that IBM's shift to new markets is taking hold is the jump in gross profit margin of late. Not surprisingly, margins from services -- like IBM's strategic imperatives -- are generally higher than those for hardware sales. And IBM has grown its gross margin from around 40% a decade ago, to last quarter's 50% on a non-GAAP basis (excluding one-time items).
If your investment time horizon is next month, IBM isn't a great fit. But if you're looking to next year, and beyond, IBM is trading at less than 9 times future earnings, offers the aforementioned nearly 4% dividend yield, and, most importantly, it's making strides in its strategic imperatives. In other words, it's growing where it counts.