IBM's Cash Flow Issues Are Still Weighing on Its Stock

In 2017, IBM's (IBM) free cash flow (FCF) snapped a multi-year decline by rising 11% to $13 billion. But that was still well below its peak of $18.2 billion reached in 2012, and Big Blue disappointed investors in its fourth-quarter earnings report in January by forecasting FCF would drop by about $1 billion this year.

Judging by what the IT giant just shared at an investor briefing, it could still be quite a while before FCF approaches 2012 levels.

At its briefing, IBM reiterated a "longer-term model" of achieving low-single-digit revenue growth and high-single-digit EPS growth. But the company also guided for its FCF realization, defined as the percentage of GAAP net income that converts into free cash flow -- arguably the best metric for gauging how much cash a business takes in versus how much it spends -- to only be above 90%.

The FCF realization target is below the 104% realization rate that IBM has averaged over the last three years, excluding the impact of a $5.5 billion 2017 charge related to tax reform. Moreover, IBM's GAAP net income, which the realization rate is based on, has pretty consistently been lower than its non-GAAP net income, which headline consensus EPS estimates rely on.

IBM shares fell 1.3% on Thursday following the disclosure. Shares are roughly flat on the year, but down 8% from where they traded prior to the company's Q4 report and call, when it gave its initial FCF guidance.

Excluding the tax reform charge, IBM posted 2017 GAAP EPS of $11.98, 13% below reported non-GAAP EPS of $13.80. Likewise, although the company is guiding for 2018 non-GAAP EPS of "at least" $13.80, the GAAP EPS consensus stands at $11.88. For 2019, the GAAP and non-GAAP consensus numbers are $12.24 and $14.18, respectively. Thus IBM's model suggests FCF per share will be more than 10% below its non-GAAP EPS per share in the years to come, and perhaps closer to 20% below it in some years.


IBM is forecasting little or no revenue growth for three of its four main reporting segments.

On the bright side, IBM's target of high-single digit, long-term EPS growth is above consensus forecasts for 2% 2019 growth and 4% 2020 growth. Stock buybacks will help out some here: IBM is modeling a 2% annual share count decline.

But IBM also expects EPS to get a boost from a revenue mix shift towards its highly profitable Cognitive Solutions division, as well as from steady gross margin (GM) expansion "as-a-service" cloud app, infrastructure and platform revenue streams, some of which have had relatively low margins. IBM sees Cognitive Solutions, which contains much of Big Blue's software operations, posting mid-single digit annual growth, and it sees as-a-service GMs growing by three percentage points per year.

Margin improvement at IBM's Global Business Services (GBS) division and giant Technology Solutions & Cloud Platforms (TS & CP) unit will also help: Each segment is expected to see about half a percentage point of margin expansion per year. And IBM is also forecasting its spending growth will trail its revenue growth in the coming years.

Nonetheless, the depressed FCF guidance suggests that after many years of aggressive financial engineering, IBM is going to be hard-pressed to deliver major cash-flow growth in the absence of major revenue growth. And revenue growth, in turn, is expected to be limited as growth opportunities in fields such as cloud apps/services, analytics software and security offerings are offset by long-term pressures elsewhere.

Those pressures, which included smaller IT contract sizes, the adoption of Amazon Web Services (AWS) and other major cloud infrastructure platforms and stiff competition from the likes of Action Alerts Plus holding Microsoft (MSFT) , Oracle (ORCL)  and Accenture (ACN) , are likely key reasons why IBM is only aiming for low-single-digit growth for its GBS and TS & CP segments. And also why Systems (hardware plus OS software) revenue, currently benefiting from a strong mainframe upgrade cycle, is only forecast to be "stable" after adjusting for cycles.

Big Blue's outlook provides some additional context for Berkshire Hathaway's (BRK.A) recent decision to unload most of its IBM position, which it began accumulating in 2011. Warren Buffett, who cares quite a lot about the free cash flow delivered by the companies his firm invests in, couldn't have been pleased that IBM's FCF remains well below where it stood when Berkshire first invested in the company, and doesn't appear set to rebound to those levels in the near-term.

While IT giants such as Microsoft and SAP (SAP) have cracked the code for delivering healthy revenue and FCF growth in the face of rapid cloud app and infrastructure adoption, IBM's attempts to do the same are still very much a work-in-progress. And the company's shares, which remain close to where they traded when Berkshire first took a stake, are being priced accordingly.