IBM Earnings: Why the Selloff Is Misguided

To say that technology giant International Business Machines (NYSE: IBM) has had a challenging last few years would be putting it mildly. Shares of IBM are down 10% in just the past two years.IBM-earnings

IBM’s problems stem from its inability to adapt to a new technological age. For many years, the company was a juggernaut in the technology hardware space. More recently, however, it has struggled to get a foothold in new areas of technology like the cloud.

Once again, IBM’s disappointed investors when it released its second-quarter earnings report Monday after the closing bell. Even though IBM earnings beat analyst projections, it missed on revenue. The stock fell nearly 6% Tuesday on the news.

But here’s why long-term investors should continue to be patient with IBM.

Currency Woes Persist, But Recovery Remains on Track

On the surface, IBM’s results look very bad. The company reported earnings of $3.84 a share on revenue of $20.81 billion. Both figures represent 13% year-over-year declines. Last quarter marked the 13th quarter in a row of falling revenue for IBM.

Wall Street projections called for $3.78 per share of earnings on $20.95 billion in revenue. As a result, IBM actually beat on EPS expectations, although revenue fell short. This is a familiar theme for IBM, which has missed revenue targets for several quarters in a row but has been able to beat on EPS thanks to its cost cuts and large stock buybacks.

As a result, it’s no surprise why the stock has performed so poorly for the past few years. But it’s also worth noting that currency headwinds played a very large role in IBM continuing its dubious streak of falling revenue.

IBM’s revenue was negatively affected by unfavorable currency exchange by nine full percentage points. Divested businesses accounted for an additional four percentage points of revenue decline. Excluding these factors, and IBM’s revenue would have actually increased 1% year-over-year.

The strong U.S. dollar has been a huge weight for large multinational companies like IBM, which have made emerging-market growth a huge priority. Collectively, IBM’s revenue from the BRIC nations (Brazil, Russia, India and China) declined 35%, or 18% adjusting for currency and divestments.

But IBM’s turnaround remains on track. The company’s “strategic imperatives,” including Big Data, the cloud and security, grew revenue by more than 30% over the first two quarters of the year, adjusted for currency and divestments.

Cloud revenue soared more than 70% adjusted for currency and cloud delivered as a service has reached an $8.7 billion annualized rate. Social revenue jumped more than 40% year-to-date excluding currency, and mobile revenue has more than quadrupled.

And the U.S. dollar can’t rally forever. At some point, international currencies will recover, and at that point currency will become a tailwind instead of a huge headwind.

Cash Returns Are Still Attractive

While IBM’s stock price has not done well, and its headline earnings numbers look weak, the company still generates a lot of cash. IBM expects free cash flow to actually increase slightly from 2014 levels. This is a testament to the underlying strength of its core business, which can be difficult to see given the headline declines in revenue and EPS due to the strong U.S. dollar.

With its strong free cash flow, IBM maintains a generous cash return policy. The company utilized $1.1 billion of cash to buy back stock last quarter and another $1.2 billion to pay dividends. IBM pays a solid 3% dividend, and earlier this year it increased its dividend by 18%.

Plus, the stock is very cheap. IBM trades for just 10 times its full-year earnings guidance.

As a result, while IBM’s transformation requires patience, long-term investors willing to ride out the bumpy weather will likely be rewarded.

DISCLOSURE: Bob Ciura personally owns shares of IBM.

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