[Editor’s note: This story has been edited to correct a misstatement concerning the status of Watson Health.]
The case for IBM (NYSE:IBM) stock seems reasonably easy to make. For one, International Business Machines stock (as it’s sometimes known) is among the cheapest issues in the market. IBM stock trades at just 10x 2019 EPS estimates and yields a healthy 4.5%.
That combination seems like it should be an attractive one for the longtime tech giant. And indeed, I recommended IBM stock on two occasions last year, most recently amid a sell-off in November. There was – and still is – a “get paid to wait” argument for betting on a turnaround. I myself sold puts on IBM early last year, with the goal of either keeping a healthy premium or acquiring International Business Machines stock at a more attractive price.
The problem with IBM stock, however, is that the combination of a cheap price and a solid yield has held for years now. And over that stretch, IBM shares simply have kept falling. The stock actually touched a nine-year low in December. Even with a rally of late, IBM trades more than 20% below early 2017 highs. For nearly three years now, IBM has been a yield trap.
For that to change, the turnaround needs to take hold. And while there’s still hope, the recent Q1 earnings report hardly showed much progress. IBM stock still is cheap – but until the underlying business improves, it very well might stay that way.
IBM Falls After Earnings
IBM infamously posted 23 straight quarters of declining revenue (on a year-over-year basis) before breaking the streak with the Q4 2017 report. Unfortunately, Big Blue is back to its old ways.
Three straight quarters of growth have been followed by three straight quarters of decline. In those previous three reports, IBM has fallen short of consensus revenue estimates each time.
In Q1, sales fell 0.9% year-over-year, even backing out currency effects. Pre-tax margins did expand sharply (some 300 basis points) but a comparison against one-time charges in the year-prior quarter was a big help. EPS, in part due to a higher tax rate, actually declined to $2.25 from $2.45 the year before.
From a broad standpoint, it doesn’t look like enough, and the 4%+ decline in IBM stock makes some sense.
A Closer Look at Earnings
That said, looking at the quarter more closely results in an “eye of the beholder” situation. For instance, a big issue in the quarter was mainframe sales: IBM Z revenue dropped 38%, per the IBM Q1 conference call. But as The Motley Fool pointed out, that’s in part due to the mainframe cycle that may rebound in 2020 or 2021 as a new product is released.
At the same time, however, it was that same cycle that largely drove the three-quarter stretch of growth a year ago. Without that cycle, IBM still is a long way from keeping revenue stable.
Outside of mainframe, the news looks mixed. Unsurprisingly in the current climate, IBM seeks some growth in key areas. Constant-currency cloud revenue grew 12%, per the Q4 call; that business, over the past four quarters, now has generated about a quarter of total revenue. Consulting revenues are up.
But there’s a bit of a “rising tide lifts all boats” phenomenon there. Cloud revenue should be rising and perhaps should be rising much faster. Different companies have different definitions of “cloud”, but the 12% rate clearly lags those of other tech giants like Microsoft (NASDAQ:MSFT) and Amazon.com (NASDAQ:AMZN). It’s difficult from the numbers to believe that IBM is gaining market share; rather, its positioning seems to be eroding in a fast-growing market.
Watson increasingly looks like a disappointment. Cloud & Cognitive Software, on the whole, grew constant-currency revenue just 2% in the quarter. However, according to a statement by IBM Watson Health spokesperson John Roderick, the company is not discontinuing its efforts here. Instead, IBM will continue to focus its efforts on existing Watson for Drug Discovery customers:
“IBM is not discontinuing its Watson for Drug Discovery offering, and remains committed to its continued success for clients currently using the technology,” Roderick told InvestorPlace. “IBM is focusing its resources within Watson Health to double down on the adjacent field of clinical development where the company sees an even greater market need for its data and AI capabilities.”
Indeed, IBM is growing in seemingly hot areas like cloud and AI. That said, it’s declining elsewhere and not growing fast enough where it should be. It certainly is not keeping pace in stronger end markets. As those markets slow and we’ve already seen cloud worries hit chip stocks like Nvidia (NASDAQ:NVDA) and Intel (NASDAQ:INTC) – IBM’s growth will slow, too. What does the story here look like then?
How to Play IBM Stock
That said, IBM still is cheap, and I’m not sure the case is terribly different from what it was a year ago. There’s still hope; there are still valuable businesses in-house, and the acquisition of Red Hat (NYSE:RHT) should help revenue and profit growth (though interest expense will limit the initial bottom-line contribution).
For now, there’s enough to see International Business Machines stock muddling through and maybe even to see the dividend as attractive. It’s worth noting that other low-growth/turnaround tech plays, Oracle (NYSE:ORCL) and Cisco Systems (NASDAQ:CSCO) being the two best examples, have soared of late. Those companies have shown a bit more promise, but they also highlight the potential upside here if IBM can change the narrative.
The catch remains, however. For real upside in its shares, IBM has to change the narrative and Q1 wasn’t enough to do that. Taking the longer view, it’s difficult to ignore recent history, and unwise to buy IBM stock simply because it’s cheap. It’s been cheap for a while, and that’s done little for IBM shareholders.
Selling puts (or covered calls) can hedge exposure, and lower the effective price here; that maybe makes IBM more attractive. At a certain point, IBM simply has to drive growth one way or another. Investors have been waiting a long time for that to happen and after Q1, they’re still waiting.
As of this writing, Vince Martin has no positions in any securities mentioned.