IBM's Bottom Line Matters Now More Than Ever

NEW YORK ( TheStreet) -- It's starting to look more and more as if investors have given up on IBM's ( IBM) growth prospects.

While no one can dispute IBM is a well-run company, growth has not been "Big Blue's" strong suit, despite having spent over $16 billion the past five years in the effort.

Nevertheless, as investors lower their expectation, the stock has risen 75% over the past three years -- including 7% so far this year. Remarkably, this year's gains include fourth-quarter results that I would consider "so-so." Granted, margins arrived better than expected but the shares have already reached a level not expected until the second half of the year. IBM's name still carries weight.

IBM would make everyone's top 10 list of dominant tech names. While the balance sheet is nice, the company is getting left behind in several categories by much nimbler ( CRM) and cloud titan Oracle ( ORCL), which continues to strengthen its enterprise position after another recent acquisition.

Then again, not many rivals enjoy IBM's strong margins either. Where IBM falls short on growth, the company often makes it up where it matters the most - on the bottom line, including in the recent quarter with margins arriving at 48.1%. Likewise, gross margins advanced more than two points year over year.

For that matter, there were margin improvements in every segment, which is interesting for several reasons, not the least of which is IBM posted soft revenue of $29.09 billion representing a decline of almost 1% year over year.

This was the third consecutive quarter of declining sales. But none of this mattered. Here's why.

Consider: As IBM has posted sales declines during the past three quarters, both Oracle and have grown revenue during that span. For instance, compared to IBM's 3% software revenue growth, Oracle just ended its recent quarter with software licenses surging 17%. Likewise, reported 34% increase in the same category. Essentially, IBM has been ceding market share to both companies.

But that's not all. While posted a 35% year-over-year increase in service revenue, IBM posted a 2% decline in the same category. However, IBM still managed to report $5.8 billion in net income, or a 6% increase year over year. When excluding one-time items, earnings were $5.39, easily exceeding Street estimates of $5.25 per share.

This is where IBM's brilliance comes in. Despite the obvious market share loss during the quarter, the company still brings in tons of cash, all helped by its incredible margins. In other words, revenue growth is no longer the engine that drives the stock. This is what investors have come to appreciate. Profitability has taken over.

To that end, IBM has been working hard to improve its operating income, which grew 10% year-over-year, with operating margins showing an improvement of over 2.5 points. Clearly, the company continues to do well squeezing every penny out of the customers that it has.

The fourth quarter was far from breathtaking. Nevertheless, it was enough to appease investors, upon which IBM's CEO Ginni Rometty offered:
Our performance in the fourth quarter and for the full year was driven by our strategic growth initiatives -- growth markets, analytics, cloud computing, Smarter Planet solutions -- which support our continued shift to higher-value businesses.

Rometty's reference to higher-value business has been a clear focus, which showed in IBM's strong margin performance. Although the growth story is no longer a story, I worry the company can become vulnerable to the stronger growth players once tech spending recovers.

Although the high margin business strategy is working well today, it's only a matter of time before SAP ( SAP) or Hewlett-Packard ( HPQ), which is desperate for growth, figures out a way to apply margin pressure. This would then put IBM in a tough situation, especially since the company just posted a 2% decline in service revenue.

If there is a bright side, it's that overall revenue advanced 18% sequentially. While this may have been due to postponed orders placed in the fourth quarter, it's certainly an encouraging sign. Meanwhile, it's too hard to fall in love with the stock at the moment.

The recent 7% surge was a surprise, and I expect a slight pullback to under $200 -- albeit temporarily. But over the long term, IBM's story has not changed.

This is still a solid play on tech and the stock should reach $220 by the end of the year. The only thing that has changed, however, is growth has become overrated. But value in the bottom line still matters.

At the time of publication the author had no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.
Richard Saintvilus is a private investor with an information technology and engineering background and has been investing and trading for over 15 years. He employs conservative strategies in assessing equities and appraising value while minimizing downside risk. His decisions are based in part on management, growth prospects, return on equity and price-to-earnings as well as macroeconomic factors. He is an investor who seeks opportunities whether on the long or short side and believes in changing positions as information changes.