April 20, 2016 at 3:18 pm #3227
Hi IOI! I am wondering about IBM's recent reporting of their quarterly performance. I was reading some analysis from an independent third party analyst and he made the following three points about the “poor quality” of IBM's earnings numbers:
“IBM's performance was enhanced by 1) a low tax rate, 2) share buy backs and 3) cost cutting maneuvers.” He also talks about revenue, gross margins, operating income and net income all having fallen in the recent reporting period.
I am wondering how the OCP metric we use at IOI deals with this. I know IBM's in the midst of a massive restructuring, but I cannot tell where reality is on their earnings numbers and what's really good or bad?
Thanks for your help/insight?April 20, 2016 at 6:39 pm #3228
Just read through the IBM piece you mentioned and here’s what I thought:
1. The analyst who wrote this (I worked with him at Morningstar) is focused on revenues, gross profit, op profit, and NI being down. I’ve seen OCP increasing for the past few quarters even in these circumstances, so I am counting on most people focusing on the things I don’t care about as much as the thing I do care about improves. That’s a good situation to be in, I think. The idea that people would consider gross margin important is silly to me, in fact — there is so many more costs that must be considered before a company can share profits with its owners, it hardly makes sense to spend a lot of time hand-wringing about it. It's like someone running a 100-mile ultra marathon worrying that his first mile time was a little slow…
2. There seems to be something that gave them some tax benefit this quarter. I haven’t looked at that yet, but I don’t think it matters that much. The only thing that matters is that when people with a sell-sider approach (like the analyst that wrote the piece) reverse out that tax boost, whether the EPS came in under (or at?) what they had forecast for the quarter. IBM had a reversal in taxes at the end of last year that was positive, but that was more than offset by negatives from building asset accounts. In the end, I don’t think it is just a bookkeeping anomaly regarding taxes that is affecting OCP positively.
3. The analyst has this strange idea (which is born out of orthodox Efficient Market Hypothesis-style arguments) about stock buybacks “destroying value” if they are made at a price higher than what he considers the fair value of the firm. This is a solipsistic point of view and based on what? His assumptions regarding cost of capital, “ROIC”, etc. IBM’s business is shrinking. The managers are trying to shrink the capital base to make sure that it is congruent with the smaller size of the firm. I would wonder if he would rather they didn’t shrink the capital base, see the shares crash, then buy back the shares at a cheap price?! It’s hard to believe that’s something that a good steward of capital would do – certainly, a CEO could not expect to keep their job in that situation.
4. Right now, my best-case revenue change is -5% for this year (2016). Worst-case is -8%. Looks like this quarter’s revenue is in-line with best-case revenue projections… I hate to look at profitability again so soon after I already did it, and IBM doesn’t publish very good CF statements with earnings, so it’s hard to say, but it looks like OCP again was very strong – even backing out $1 billion in tax-related inflows.
All-in-all, IBM is a very uncertain business for the reason that I've written about before. The revenue uncertainty is fairly large and the fact that the way the company accounts for revenue makes things even more confusing. For example, let's say that last year, IBM sold a client a one-year license to an on-premise piece of software for $120. This year, rather than selling the on-premise software for $120, they sell a subscription to a Cloud software package for $120. In the first case, IBM could recognize $120 as soon as the software was delivered; in the second case, IBM could only recognize $30 of revenue for the first quarter because it is selling a subscription and recognizing the revenue “rateably”. Nothing has changed in the economics of the transaction; only the delivery method has changed, which has necessitated revenue be recognized another way. This will show up as a 75% drop in revenues and hugely lower margins because all the general costs of the company will be spread over 75% less revenues that quarter.
IBM is going through thousands of these types of switch-overs globally, so it is very hard to know what's going on exactly. It seems as though I've modeled the revenue and profits fairly accurately, so now the value hinges on the value of the investments that it is making in analytics, security, and the Cloud.May 25, 2016 at 2:18 am #3419
To Erik's point #1 – I believe that gross profit and gross margin analysis can be very valuable, but more the the managers of a business. While it can assist management in understanding and guiding a business it's usefulness in valuation is limited. No one would expect a grocery store operation to move towards the margins on a luxury goods retailer. Furthermore, in my experience businesses that try to adhere to a single gross margin, much less an perpetually expanding margin, do not thrive over time. So with this slight exception – I agree with Erik.October 8, 2016 at 3:55 am #4621
Just saw your post! Thanks for the comment. Right on target, as usual. Being inside a company allows people to look at a company in a very different way. For instance, I think ROIC is the dumbest thing for an external investor to think about because we never know how much capital is getting invested in any project and because we have to make so many baseless assumptions in the process that the calculation loses meaning. But for someone with access to the actual records of the company, you can say, we spent $100 on this and already we've netted $80 of profit after 18 months (or whatever). In that case, as long as you are accurately reflecting the costs of the project, it makes perfect sense to talk about ROIC.
Thanks again for the comment!
All the best,
ErikJune 29, 2018 at 10:21 pm #9712
Does Oracle’s results along with other tech companies like Red Hat and Workday mean that IBM’s results will likely be disappointing?July 5, 2018 at 4:56 am #9716
Thanks for the question!
Regarding Oracle, in fact, the numbers themselves were not bad. Media reports mentioned “soft guidance”, but in fact, the guidance was pretty strong — growing momentum in the fourth quarter, current year's revenues increasing over last year's, etc. I think that what the market reacted to – and what I reacted to as well – is the idea that Oracle is trying to obfuscate the state of its Cloud business through concealment of the detailed numbers.
I have always framed Oracle as different from IBM as different from Amazon, Google, and the rest. IBM is building a franchise around AI, hybrid cloud, security, and (eventually) quantum computing. Oracle is focused on providing critical software on which business run critical processes. Since its acquisition of Sun Micro, it has also had a high-end hardware focus that is similar to IBM's mainframe business in concept. An IBM mainframe and a Sun server are not equivalent in a technical sense, but in a commercial one. Namely, for most clients, an x86 server running some software – perhaps Oracle, perhaps an IBM database, perhaps Salesforce – meets their needs. However, for another small subset of clients, there are good structural and commercial reasons why they must use a higher-performance system. That is not a huge business, but it is a profitable one, and because Oracle is able to tune its servers to run its databases and software applications very quickly, the hardware business supports the software business and vice versa.
Long story short, even though these firms all compete in the Tech space, their franchises are different and their competitive offerings different as well. IBM's next quarterly earnings report may have a positive surprise or a negative one. I have no idea which it will be. I am pretty confident that my valuation model captures IBM's economics longer term pretty well.
Oracle is a different matter. I had thought and hoped that ORCL would experience a religious transformation and realize that giving Larry Ellison more stock grants to further align his billionaire's interests with my non-billionaire's interests is folly. In other words, I thought that the degree to which ORCL would take care of its non-managerial owners better over time. I'm starting to realize that there is little proof to show that this transformation is underway. Oracle submitted its 10-K at the end of June, so I'll take a look at it and reassess. I'll especially be looking at the anti-dilutionary stock buybacks looked like in FY2018.
All the best,
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