Investors sold off International Business Machines (NYSE:IBM) following earnings on Monday afternoon. IBM stock slipped 3% in trading Tuesday.
At first glance, it’s not hard to see why. IBM’s profits did beat Wall Street expectations, but earnings per share declined 18% year-over-year. Amid the response to the novel coronavirus, IBM withdrew its full-year guidance. Bulls came into 2020 hoping for a return to revenue growth. Those hopes appear dashed.
But looking closer, the quarter supports the turnaround case I made for IBM stock ahead of the report. The core of that case is that the acquisition of Red Hat better positioned IBM to compete in the fast-growing cloud space.
The numbers don’t seem to show much progress toward that goal. The commentary does, however. And if IBM indeed is becoming a bigger and better player in cloud, then IBM stock almost certainly will rally from here.
Disappointing Earnings …
Again, on their face, Q1 numbers look disappointing. Skeptics simply don’t believe that IBM can return to growth. Much like General Electric (NYSE:GE) or Kraft Heinz (NASDAQ:KHC), bears argue that IBM is a formerly great American company that hasn’t been successful in competing in the modern economy.
Those skeptics likely won’t be converted by first quarter numbers. As noted, adjusted earnings per share fell 18% year-over-year. Revenue fell 3.4%.
IBM infamously saw sales decline year-over-year for 22 consecutive quarters before finally breaking the streak in the fourth quarter of 2017. Three quarters later, it returned to its negative-growth ways: even with help from Red Hat, it couldn’t get back to growth in Q1 after a top-line increase of just 0.08% in the fourth quarter.
… Are Better Than They Look
But it’s important to remember the context of the quarter. The coronavirus shutdown had a significant effect on performance in March, the last month of the quarter.
Here’s how chief financial officer Jim Kavanaugh framed the quarter on the earnings call:
As we got into March…we saw a noticeable change in client priorities. With that, there was effectively a pause as clients understandably dealt with their most pressing needs. This was most pronounced in our software business, where the vast majority of transactions typically closed in the last two weeks of the quarter.
For those clients that did engage at the end of the quarter, there was a noticeable change in priorities where focus very quickly shifted to the stability of their operations and preservation of cash. They moved ahead with spending that addressed immediate and essential needs, including running mission-critical processes and securing a remote workforce.
In fact, Kavanaugh told Barron’s in an interview that IBM actually was set to beat guidance, with “strong double-digit growth” in software.
Cloud no doubt was a big contributor on that front: revenue in the category rose 23%, according to the earnings call. Red Hat still is growing at a 20% clip. Internet of Things performance was “strong.”
So I see two positive takeaways from the quarter. The first is that IBM was on track until the coronavirus pandemic upended its business. The second is that the categories that have to drive growth going forward still performed reasonably well.
Those takeaways both matter to IBM stock. They matter more than altered 2020 guidance.
The Case for IBM Stock
Throughout this recent crisis, I’ve urged investors to take the long view. IBM is a perfect example why.
It’s modestly disappointing that IBM is pulling its outlook for this year. But in terms of IBM stock, that shift simply doesn’t matter all that much.
Stocks are valued based on the expected value of their future cash flows. That’s all of their cash flows, not just those coming in the next few months or few quarters.
And what IBM is telling investors is that its future cash flow really hasn’t taken that big of a hit. IBM in March didn’t lose business it’s never going to get back; its customers simply had other, more pressing, matters to deal with.
That business will be back in play once some sense of normalcy returns. Cloud demand isn’t going to wither. The IoT megatrend isn’t going anywhere.
In fact, there’s even a case that delayed installations by businesses are good news for IBM stock over the long haul. IBM, after all, is trying to catch Amazon (NASDAQ:AMZN) and Microsoft (NASDAQ:MSFT) in cloud. (Interestingly, Kavanaugh told Barron’s that newly disclosed figures from Alphabet (NASDAQ:GOOG,NASDAQ:GOOGL) suggest IBM’s cloud business is twice as big as that of Google.)
If decisions are pushed toward later this year or early 2021, that gives IBM more time to make its case. It creates a longer runway for Red Hat’s “hybrid cloud” solution to take hold. Adoption of the Kubernetes platform will broaden.
Ignoring the positives here because of 2020 guidance simply doesn’t make sense. This isn’t a normal operating environment for IBM. It’s not a normal operating environment for anybody.
What matters is what a company, and a stock, will look like once normalcy returns. Q1 suggests IBM will look better than investors seem to believe.
Matthew McCall left Wall Street to actually help investors — by getting them into the world’s biggest, most revolutionary trends BEFORE anyone else. The power of being “first” gave Matt’s readers the chance to bank +2,438% in Stamps.com (STMP), +1,523% in Ulta Beauty (ULTA) and +1,044% in Tesla (TSLA), just to name a few. Click here to see what Matt has up his sleeve now. Matt does not directly own the aforementioned securities.