When Does IBM Become Overrated?

NEW YORK ( TheStreet) -- If you're a tech investor and have not been in a state of perpetual worry, you're probably not paying attention. Closing your eyes in bliss works only until you're rudely awakened to disappointing results. To that end, IBM's ( IBM) first quarter did just that.

Investors shouldn't have been surprised, however. The brutal reports already issued by Oracle ( ORCL) and Red Hat ( RHT) have elevated fears that enterprise spending has not fully rebounded. Big Blue did very little to calm the panic.

Plus, given that the stock had already carried some higher expectations when compared with some other enterprise-spending-dependent names, investors wasted no time selling IBM's stock. Shares declined more than 10%, falling below $190.

Now that IBM has recovered some of those gains and is back above $200, I'm grappling with whether or not the optimism is deserved. Given the recent lack of growth, it's worth asking: At what point does IBM, despite its great history, become overrated?

Don't confuse this with me saying that IBM is a bad company. After all, there's no way that one soft quarter, or for that matter even four quarters, should negate what IBM has been able to accomplish in its history. However, the pattern of unimpressive if not pathetic growth is noticeable. And it seems that IBM is operating on a different set of standards.

Disappointing First Quarter

IBM has been a very profitable company. But there has been very little growth over the years, despite the fact that the company has spent more than $16 billion over the past five years in acquisitions trying to grow the top line. This recent quarter, during which revenue dropped 5%, was no exception -- marking the first time in eight years that the company has missed.

As with the fourth quarter, there were some struggles in IBM's services business, which posted a 4% decline in revenue following a 2% decline in the fourth quarter. While this is not entirely a surprise given that Oracle had just posted a 2% decline in revenue, which was mostly due to weak cloud subscription services, it's disturbing for IBM because the services business is the company's largest unit.

However, management was able to offset this weakness in software, which advanced 1% year over year. But here too the company is being outpaced by Oracle. Plus, a case can be made that even Salesforce.com ( CRM), which has done an excellent job building itself into a leading software-as-a-service (SaaS) business, is winning market share from IBM.

What's more, even though IBM's 1% year-over-year revenue improvement is encouraging, especially given the weak tenor of tech spending, the performance still fell short of Street estimates. This is while hardware revenue arrived down 13% when excluding discontinued businesses.

The feeble hardware situation is important for several reasons. Though I expect IBM to navigate through this period unscathed, it certainly doesn't bode well for the likes of HP ( HPQ) and Dell ( DELL), which rely heavily on server revenue. To that end, it does seem as if the competition is beginning to chip away at IBM's profitability.

Ordinarily, the bottom line has always been a standout for IBM as the company has consistently gone after higher-margin business. Even though the company did beat estimates on non-GAAP gross margin, the fact that gross margin increased by only one point was a disappointment, especially because IBM advanced gross margin by more than two points in the fourth quarter. Plus, it didn't help that adjusted operating income fell by 1%.

There are numerous scenarios that can be extracted from these results. The first is that, given the revenue decline, we can safely say that IBM is seeing increased competition from Oracle and Salesforce.com, which have also begun to chip away at IBM's margins. What's more, we can't rule out the progress that SAP ( SAP) has made in the SaaS market, either. Where does IBM go from here?

This quarter's report notwithstanding, IBM deserves a considerable amount of respect for its bellwether status. But it's nonetheless remarkable how the company has escaped the wrath of investors over the years even as its growth has slowed to a crawl. The company has figured out ways to be seen as more shareholder-friendly.

Aside from sporting some of the best margins in the business, very few companies can compare to IBM when it comes to return on equity. This is while the company has also paid a handsome dividend. There are also companies like Apple ( AAPL) that can boast the same things.

But in Apple's case, the stock had plummeted 45% in seven months to its recent low of $385. Although the shares have since rebounded close to 17%, you would think that the deluge of negative headlines that preceded the declines that Apple was on its deathbed. Yet Apple had just come off a first quarter during which revenue grew 18% year over year to $54 billion.

Similarly, in Apple's second quarter, although revenue arrived up at just 11%, the performance sure as heck beats IBM's 5% decline. Nevertheless, all we hear is how Samsung's been eating Apple's lunch, while Google ( GOOG) serves it on a platter with the help of Android. But if that's true, then given IBM's lack of growth over the years, it must also be true that Oracle and Salesforce (among others) have been bullying IBM around.

Remarkably, though, IBM's stock has never fallen more than 15% over the past 12 months, whereas Apple's valuation was almost cut in half. This despite Apple beating IBM in every statistical category that matters, including cash and debt. If Apple is seen as on the decline and overrated, why isn't IBM?

At the time of publication, the author was long AAPL..

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 the founder and producer of the investor Web site Saint's Sense. He 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.