IBM reported disappointing 4Q20 earnings although there were positives that support Northlake’s investment thesis.  EPS exceeded expectations, but the upside was due to below-the-line or non-operating items.  The culprit in the quarter was revenue weakness.  We are not surprised by a revenue shortfall given IBM has a lot of exposure to on-premises enterprise spending in its hardware, software, and consulting businesses.  However, weakness was broader and deeper than we expected in these business lines.  Unfortunately, management indicated 4Q20 trends were likely to continue through the first half 2021. 

The revenue miss in IBM’s historical business lines overshadowed better than expected growth of 17% in the company’s Red Hat segment.  On a sequential basis, Red Hat showed an accelerating growth rate against expectations for a slight deceleration.  Red Hat is central to Northlake’s bull case IBM.  Red Hat accelerates IBM’s shift to offering cloud services to its large installed base and provides an entrance to many new customers that look to cutting-edge technology providers.

Prior to reporting its previous quarter, IBM announced a major corporate restructuring that will split the company by spinning out much of its most growth-challenged businesses comprising the Global Technology Services segment.  GTS has had declining revenue for years and earns below corporate-average margins.  Spinning it off to shareholders will leave core IBM much more heavily focused on cloud services and artificial intelligence.  While IBM trails Microsoft Azure, Amazon AWS, and Google Cloud, the cloud businesses now being driven by Red Hat offer solid double-digit growth potential. 

With GTS gone, new IBM can offer mid-single-digit growth, rising margins, and significant free cash flow.  The stock trades at just 10X earnings.  A successful transition to a moderate growth profile would allow the multiple to expand, potential to 12-15 times earnings.  The upside is thus significant.

Unfortunately, our bull thesis is taking longer to develop than we hoped.  Partially, this is due to the impact of the COVID-19 pandemic on IBM’s large exposure to on-premise energy spending.  This is certainly not the company’s fault.  However, it is fair to wonder whether the shift to a digital economy has long-term ramifications that will keep pressure on IBM’s non-cloud and AI businesses and offset the growth they offer.

The next few quarters seem likely to look like 4Q20.  This will make for tough going for the stock.  Investors are aware of the near-term challenges after the difficult finish to 2020, which should protect downside in the shares.  IBM also has a secure dividend that provides a current yield of over 5%.  Business trends should improve in 2H21 and in 3Q21, the company should provide full details of its spinoff and restructuring. 

We are not sure if it is worth waiting another six months or more for our bull thesis to begin playing out.  Results in 2020 were impacted by the pandemic but it is fair to suggest they also push back against the timing and probability of the bull case.  Right now, we are sitting tight as we reevaluate our IBM investment thesis.  The bad news is out.  The valuation is low.  The current yield is high.  We believe these factors give us time for further analysis.

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.