IBM Q1: Big Blue Sees Crimson As It Blows Money On HashiCorp

Timing is everything in markets. When we last covered International Business Machines Corporation (NYSE:IBM) we looked at the results and the valuation and felt that this was almost there at the right level for investors to exit and not look back. Specifically, we said:

The only time when it was more expensive was when sales fell post COVID-19 and the stock rebounded back. At present, the odds of you making money here over the medium term look slim. The business is doing ok, but has long term structural headwinds. A push into the cloud will further challenge the stodgy business lines and AI will be margin compressing for IBM in the long term. With this euphoria in place on the results, we think the stock could run to the low $190’s and perhaps even eclipse $200. We would use the opportunity to sell.

Source: Solid Q4 Results Take The Stock Into Sell Territory

Valuation is an inaccurate tool for what happens in the short term, but IBM followed the script nicely. The peak was at $199.18, a number that we don’t think will be surpassed any time soon.

We look at the results and the HashiCorp (HCP) acquisition today and tell you why the path of least resistance lies towards $140.00 per share.

Q1-2024

IBM did beat on earnings per share but tracked soft on revenues. Astute investors understand that most companies tend to meet or exceed earnings guidance even in the worst of times, but revenues tend to lead the real story. Software saw a solid result, with year-over-year growth coming in at about 6% at constant currency exchange rates.

There was the usual quarter-over-quarter drop-off, but that is expected with this segment. Consulting unfortunately grew at only sub-inflation rates and came with the dreaded warning which no one paying such expensive multiples likes to see. IBM’s clients were pulling back.

This is typical in late cycle as different companies hit their peak profits at different times and then pull back their own capex. In the third segment, Infrastructure, IBM’s revenue was a rounding error and this apparently was from the benefits of AI.

We would hate to see what these would like without AI helping out.

You can see some different numbers in the IBM report, which are changes without adjusting for currency fluctuations. But the two sets are fairly close, as the US dollar has not moved much relative to Q1-2023. The positives in this report came from the strengthening of gross margins, despite some major headwinds from inflation.

Profit Margin- Gross Profit Margin: GAAP: 53.5 percent, up 80 basis points; Operating (Non-GAAP): 54.7 percent, up 100 basis points- Pre-Tax Income Margin: GAAP: 7.4 percent, flat; Operating (Non-GAAP): 11.5 percent, up 130 basis points.

Source: IBM Q1-2024 Press Release

Outlook

IBM maintained its free cash flow outlook for the year at $12 billion. While it is always good to see profitable technology companies (versus the cash burners), one must put the number in context. Whether you look at Enterprise value or Market Capitalization, this is not a lot, especially in context of peak cycle growth being nothing to write home about.

As we had previously opined, the stock-based compensation continues to leak higher and the “real” free cash flow yield needs to be adjusted for this.

IBM’s gross profit margin continues to look splendid, as we are seeing new highs on this metric.

One might see this as a positive sign, but we see this as a major problem with the bull thesis. The fact that IBM has maintained its gross margins with such anemic sales are impressive.

But those margins will be a casualty in the next downturn, and they could fall quite a lot. There are no rational reasons to suspect that 59% gross margins will be maintained when the competition here is intensifying and IBM’s competitors offer multiple products within the cloud. The most rational measure here is a price to sales ratio, which will help investors not overpay for cyclical profits. At 2.744X (this is still pre-market, so the 9% drop is not reflected), it is a firm “get the heck out”.

If we did not have enough conviction just to exit on valuation, we got an extra boost from IBM’s announced purchase of HashiCorp. Yes, the bubble on that one appears to have at least partially deflated, but IBM is still buying this at 10X sales.

Even the optimistic Wall Street crowd see this growing just modestly this year and as usual, the burden of proof is passed on into the future.

Honestly, what could go wrong with buying something at 10X sales and 441X non-GAAP profits?

The ringtone this time was about synergies. Investors probably have forgotten that IBM bought Red Hat at a stupendous sales multiple because it was growing fast. That same Red Hat is now growing at a high single digit rate.

These acquisitions have not done much to change IBM’s revenue trajectory, and we don’t think this one will be different.

Verdict

If you got out when the stock drifted into our sell-zone, great. You made bank. If you did not, then that leaves you with a difficult question. Do you sell when the stock has dropped so much? We think the cycle is close to peaking and stubborn inflation rates means that the Federal Reserve won’t be coming to your rescue. In that environment, we see IBM as a high-risk play. Sure, you can argue that it is cheaper relative to Microsoft Corporation (MSFT) Accenture Plc. (ACN). That only means that you will likely lose a lower percentage. Your odds of outperforming even 10-Year Treasuries from here remains poor. While our official rating remains “hold” (we tend to use Sell only for short-selling), we encourage investors to hit the bid on this expensive offering.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult a professional who knows their objectives and constraints.