Interactive Investor

Stockwatch: The tech share I want to own 

25th January 2019 10:06

Edmond Jackson from interactive investor

Find out why our companies analyst would rather buy this cheap, high-yielding IT behemoth than Microsoft.

This last week has seen a reality check for the outbreak of investor optimism since Federal Reserve officials changed tune to a more flexible monetary stance, and hopes arose for a US/China trade deal – teased along by President Trump's tweets.  

A mid-Tuesday 400-point drop in the Dow Jones index didn't just reflect fears that trade talks had hit rocks though.  It's the wary outlook in companies reporting, once results appeared after Martin Luther King Day - Stanley Black & Decker (NYSE:SWK) came in ahead of expectations for Q4 2018 but guided earnings forecasts down for 2019, albeit less than 3%, citing margin pressure and cautioning on revenues also.  

"As we enter 2019, the external challenges don't magically disappear," it said. "There are signs that the global economic growth is slowing and that the US economy may soon be coming to the end of one of the most enduring recoveries in US history."  

Similarly, healthcare conglomerate Johnson & Johnson (NYSE:JNJ) topped Q4 expectations, but anticipates lower revenue; this is significant because healthcare is often promoted as defensive for equity portfolios, as if for peace of mind opt for bonds or cash.

Capital One Financial (NYSE:COF) upheld the mixed profile of banks reporting which I highlighted last week. It missed its revenue target, swinging from loss to profit albeit lower than expectations, and revealed a 29% jump in credit write-offs.  

Regarding consumer sentiment, London-listed Burberry (LSE:BRBY) cited weak footfall in the US where it derives about a quarter of its revenues, and December data for US existing home sales fell to the lowest level in three years.  

A redeeming feature is consumer goods multinational, Procter & Gamble (NYSE:PG), whose stock jumped nearly 5% to $95 on Q4 2018 profit up 28%, with planned price increases yet to kick in; while rival Kimberly-Clark (NYSE:KMB) cited lower Q4 revenue/profit due to higher commodity prices and currency swings.  

A dilemma for buying into Proctor & Gamble however is a price/earnings (PE) multiple around 25 times and yield of 3%, so defensive qualities look priced in, while the stock is exposed to any deterioration in its narrative or another market de-rating.

US Q4 reporting is shaping up with broadly decent numbers albeit a wary outlook, with no end in sight to a US government partial shutdown liable now to be hurting the economy.  Trade talks look – at best guess - as if some kind of compromise will be struck enabling both sides to save face, while still tackling what the US dubs as decades of state-coordinated Chinese theft of American intellectual property.  

Mind how a great many stocks in the UK – small to big cap alike – have charts resembling those in the US: late 2018 falls followed by a New Year rebound. Plenty remains to be seen to judge intrinsic value in this fluid environment.

IBM: moving to a new phase of growth?

Back in the 1990s I recall meeting at Smith & Nephew (LSE:SN.) AGMs an eclectic if a tad eccentric, retired doctor sporting a large pink bow tie. Maybe just the chap to make astute contrarian investments, he explained how he'd bought keenly into International Business Machines (NYSE:IBM) after its performance plunged, then made big profits from the subsequent overhaul as the stock soared from about $15 to peak around $200 in 2012.  

Since then, however, IBM has seen a bear market down to $110 last December, amid lacklustre financials and a need to better position for growth. The current chief executive has been in charge since 2012 and, in early 2017, finally turned the corner on six years of revenue decline. That compares with Microsoft (NASDAQ:MSFT) whose share price went parabolic from 2012 as it capitalised both on new hardware and software/cloud innovations. 

Source: TradingView (*) Past performance is not a guide to future performance

IBM's Q4 2018 saw a 3.5% revenue slip to $21.8 billion, said due to a weak phase in the mainframe computer cycle where this business plunged 44% in Q4 versus 71% growth a year before. Systems revenue also fell 21% to $2.6 billion. Earnings per share (EPS) of $4.87 was down 5% like-for-like but slightly ahead of consensus, and management guided for 2019 EPS of $13.90 versus $13.81 (on a normalised basis) for 2018.  

On the face of it, nothing to inspire, but the stock rebounded 8.5% to $133 in response as investors warmed to the story in a context where a recent PE sub-10 times compares with Microsoft on 44 times trailing earnings. Even now, IBM trades just below 14 times earnings for 2018 and, if dividend forecasts are born out, its yield rises from 4.7% to 6.3%. 

We might not get too excited about that in a UK stock market context, but in the US it stands out.  Effectively, these big tech groups are converging on a similar space of services, cloud and analytics. 

Chief financial officer heralds 'a very important inflection year'

Despite a mixed Q4, it's the first time in some years that IBM has managed to raise annual revenue, operating income and EPS concurrently. That's a bit of a stretch as, in constant currency terms, group revenue was flat at $39.8 billion, although IBM's "strategically imperative" segments broadly met a $40 billion forecast for 2018, made in 2015. Q1 expectations are for a like-for-like revenue decline, although EPS is projected for "at least $13.90" or 6 cents better than the 2019 consensus.  

While coming across as marginal changes, remember that this is a $121 billion super-tanker, so don't expect mid-cap dynamics. Potentially, the financials may indicate a turning point even if slow to evidence.

In the results conference call the CFO drew attention to the current $34 billion acquisition of Red Hat (NYSE:RHT), a software group engaged in operating systems, cloud, mobile and storage systems, on a global basis. This to me looks risky in terms of price/value – at $176 a share currently, the market cap is $31.2 billion and trailing PE multiple over 80 times – but IBM envisages synergies. 

Indeed, from the results' conference call the CFO cited "an opportunity to lift all of IBM, by selling more of our analytics and artificial intelligence capabilities across multiple platforms.  As clients proceed on their journey to get more business value from the cloud, they need more services help, from the digital design to app modernisation etc.  Our hand will get stronger with the addition of Red Hat, which positions us as the leader in hybrid, multi-cloud world."

Forecasts, where IBM's free cash flow is expected to remain steady at around $12 billion with strong conversion from earnings, exclude any contributions from Red Hat given uncertainties as to exact timing of the deal closing – its 2018 results show $279 million net income and $905 million.

International Business Machines Corp      
Annual financial results   Revenue: $million   Gross Margin: %
    2017 2018   2017 2018
Cognitive Solutions   18453 18481   78.6 77.5
Global Business Services   16348 16817   24.9 26.7
Technology Services and Cloud Platforms   34277 34462   40.3 40.5
Systems   8194 8034   53.2 49.8
Global Financing   1696 1590   29.3 29.1
Other   171 207      
  Total: 79139 79591   46.7 46.4

Not the recovery the doctor ordered, but still a 'buy'

IBM's current situation is far from its 1990s drama, but I note key factors to suggest attractive risk/reward. Despite rebounding on the results, IBM shares' earnings rating and yield price in a good element of risk: you would have to envisage serious integration problems with Red Hat, to reckon on much downside.  

True, IBM has shown itself a slowcoach wresting revenue gains and arithmetic isn't on the side of a big cap like this to deliver growth. More sets of results are needed to affirm consistent progress. But, if management can continue reasonably to deliver on its strategy, on a two-year view prospects weigh to the upside both for earning and their rating.  

Given a choice, on current information I'd rather own IBM than Microsoft. The stock's easing to about $131.50, as the market renewed frets over Chinese trade talks, shows how patience will be a virtue in the current fragile environment.  Accumulate.

*Horizontal lines on charts represent levels of previous technical support and resistance. Trendlines are marked in red.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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