After two consecutive quarters of improved results and a positive analyst meeting earlier this month, IBM’s 3Q21 earnings were disappointing.  Revenues fell slightly short of estimates, and after adjusting for a favorable tax rate, EPS did as well.  Key growth areas like consulting and hybrid cloud performed well, but software, mainframe systems, and soon-to-be spun off Kyndryl businesses all fell short.  Management admitted that the company fell short of its own expectations but noted that the spin of Kyndryl was a meaningful factor that should go away after the spin coming on November 3^rd.  We also believe the shortfall in systems is nothing to worry about as it is related to the usual mainframe cycle.

Stock Reaction: Investors punished IBM with the shares trading down about 9% following the report.  Given the recently improved results had raised expectations, the quarter came as a big negative surprise.  IBM has a poor history of earnings growth in the past decade, so traders are showing little tolerance for the shortfall and assuming the better results in 1H21 were an aberration.

Earnings Analysis: Revenue fell about 1% short of estimates.  The systems and Kyndryl shortfalls explained much of the miss, but the return of software to negative year-over-year growth was a big disappointment.  Hybrid cloud is the key to IBM’s future and Northlake’s positive investment thesis.  Fortunately, this segment continues to perform well, growing at 17%, consistent with recent trends.  Reported EPS looked a few pennies ahead of estimates but were boosted by non-operating items such as the low tax rate noted previously.  Gross margins were light, especially in the faster growing consulting business.  This raises fears that growth is coming from discounted pricing rather than competitive positioning.

Target Price: Despite the disappointment, Northlake is sticking with its bullish view of IBM and $160 target price.  The upcoming spin of Kyndryl will highlight IBM’s well-positioned hybrid cloud business.  With the shares at a P-E of just 10X – half of the average stock – expectations are low.  IBM shares are back in “show me” mode.  We are hopeful that the Kyndryl spin will improve management focus and execution.  The 9% drop looks like an overreaction and we are willing to wait given the upcoming spin and 5% dividend yield.

IBM is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts.  Steve is sole proprietor of Northlake, a registered investment advisor.  Northlake’s regulatory filings can be found at www.sec.gov.  DIS is a net long position in the Entermedia Funds.