Northlake has been monitoring IBM for some time in anticipation of an inflection point in the company’s revenue growth and margin profile.  We purchased the shares last quarter thinking that the 3Q19 and 2H19 would provide the inflection and lead to a higher P-E multiple for the shares.  At our entry point and currently IBM is trading at 10X earnings against a P-E for the S&P 500 of around 17X.

IBM reported last night and we learned that 3Q19 and 2H19 look unlikely to provide the inflection.  Nonetheless, we are sticking with our bullish outlook on IBM as there was good news despite the shortfall in operating results that led to slightly lower than expected revenue and profit margins.  In addition, we are getting paid to wait in IBM as the shares sport a 5% dividend yield and a strong single A balance sheet.  Single A is the new Triple AAA in corporate America after a decade of higher borrowing to fuel stock buybacks.

IBM’s 3Q19 shortfall was in legacy core businesses, while newly acquired Red Hat and other cloud-based products and services performed well.  The company indicated that in its largest legacy segment that about 90% of any quarter is shipped out of backlog with 10% being sold and shipped in the quarter.  In the final month of the September quarter, IBM saw a sharp decline in the quarter business, down -15%.  This was enough to penalize overall corporate revenue growth lower by -1% and drop the top line below expectations.  Given how late in the quarter the shortfall occurred, management was unable to take cost cutting actions and margins suffered disproportionately from deleveraging.  The weakness was concentrated in the UK and Germany but also feeds concerns about weaker enterprise spending that have also shown up at other IT companies over the past few weeks.  This further fuels fears that the global economy is slipping into recession and dragging the U.S. with it.  Northlake continues to believe that the U.S will avoid recession and the global economy is bouncing along at a low level but not decelerating further.

We were encouraged that newly acquired Red Hat and the company’s cloud and consulting services posted good to better than expected growth.  We expect this to continue and a boost is coming from the new mainframe cycle.  Nonetheless, it seems likely we will have to wait for the payoff at IBM as the stock will need improved performance at legacy businesses, further proof that Red Hat is working, ongoing growth in the highly competitive cloud arena, and signals that enterprise spending is holding firm.  Not all of those things are in management’s control but we think they are doing a good job with what they can control as the company is repositioned for modest long-term growth.  At 10X earnings and with a 5% dividend yield, expectations are low.  In addition, most analysts are not recommending IBM shares even though many have targets 10%+ above the current stock price.  We like the contrarian setup, low valuation, and weak sentiment and see a non-recession 2020 as the inflection point for higher revenue growth and margins and an expanded valuation for the shares.

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.