IBM's (IBM) latest earnings report did feature two pieces of good news: The Red Hat acquisition is off to a good start, and so is IBM's latest mainframe upgrade cycle.
But outside of those two positives, it was largely business as usual for Big Blue, with the company reporting little or no organic revenue growth for many large businesses and also issuing a fairly subdued free cash flow (FCF) forecast.
To recap: IBM's long-underperforming stock is up about 3% after the company slightly topped revenue and EPS estimates for seasonally big Q4, with EPS once more benefiting from a lower-than-expected tax rate. IBM also guided for 2020 non-GAAP EPS of "at least" $13.35, which compares favorably with a $13.28 consensus, and for 2020 FCF of about $12.5 billion.
The FCF guidance, which benefits a little from IBM's July 2019 acquisition of Red Hat, is above the $11.9 billion in FCF that IBM reported for both 2019 and 2018. But it's below reported 2017 FCF of $13 billion, and well below a 2012 FCF peak of $18.2 billion.
Officially, revenue was up 0.1% annually to $21.78 billion. But if you exclude the $573 million worth of Red Hat revenue that IBM recorded for Q4, while also accounting for the impact of IBM's 2019 asset sales, revenue was down fractionally.
Excluding Red Hat's sales, revenue for IBM's highly profitable Cloud & Cognitive Software segment, which contains most of its software operations, was roughly flat at $6.7 billion (after also backing out asset sales, revenue appears to have risen modestly). Global Technology Services (GTS), which among other things contains IBM's cloud infrastructure and IT outsourcing operations, saw revenue drop 4.8% to $6.9 billion, and its Global Business Services (GBS) segment saw revenue drop 0.6% to $4.2 billion.
IBM also reported that its services signings fell 9% in constant currency (CC) to $14.4 billion. This contributed to a 3% drop (in both dollars and CC) in IBM's services backlog to $112.4 billion.
For comparison, research firm Gartner recently estimated that global enterprise software spend rose 8.5% in 2019, and that IT services spend rose 3.6%. The firm also forecast that enterprise software and IT services spending would grow 10.5% and 5%, respectively, in 2020.
Simply put, IBM continues to lose market share across a number of key business segments, and -- amid secular shifts in IT spending towards cloud services and software -- is clearly accounting for a smaller portion of the IT spending done by many of its big enterprise clients than was the case a few years ago. The strategic and execution issues responsible for this ongoing share loss appear to be deep-seated and unlikely to go away in a quarter or two.
On the bright side, IBM did report that (excluding accounting adjustments) Red Hat's revenue rose 24% to $1.07 billion. That's an improvement from the 19% growth seen in Q3, and comfortably above the mid-teens growth rates the open-source software giant reported in the quarters immediately prior to IBM's purchase of the company.
For the time being, Red Hat is defying fears that it would flail under IBM's thumb, and appears to be benefiting from IBM's promised efforts to use its massive salesforce and services operations to promote and cross-sell Red Hat's offerings. On the earnings call, CFO Jim Kavanaugh mentioned that IBM nearly doubled the number of new services engagements involving Red Hat relative to Q3, and (with the help of seasonality) saw 21 $10 million-plus Red Hat deals, up from 11 in Q3.
IBM's Systems (hardware and OS software) business was also a bright spot, with revenue rising a better-than-expected 16% to $3 billion amid good demand for IBM's recently-launched z15 mainframe, which packs some interesting encryption features. Mainframe hardware revenue, which tends to be very cyclical, grew 63% after having seen major declines in the preceding quarters. But on the other hand, Power server revenue fell 23%, and storage revenue grew a modest 3%, against a backdrop of weak IT hardware spending.
Following Wednesday's gains, IBM carries an enterprise value (market cap plus net debt) equal to 12.5 times its 2020 FCF guidance. At a time when so many faster-growing, big-cap tech companies sport much higher valuations, I get the appeal of a multiple like that to value investors.
But given the lackluster performance that so many IBM software and services continue delivering, this still feels like a situation where investors are getting what they pay for.
This article has been corrected to state IBM's revenue was down fractionally after excluding both asset sales and the Red Hat acquisition.
