Next week IBM will report quarterly financials for the 2nd quarter. The tech giant is expected to report yet another decline in both revenue and EPS. While declining sales are expected, investors will be more interested in any evidence that IBM is turning the corner.

On the face of it, IBM looks cheap with a forward PE below 10. But then IBM has looked cheap for years, and for most who invested since 2013, it has proved to be a value trap. The legacy business that contributes most of IBM’s revenue is steadily declining while the much-hyped new strategic businesses are not growing fast enough to offset the decline.

The legacy mainframe segment is still a significant business, but margins are under pressure and revenue is falling. IBM’s future is supposed to be centred on the cloud, AI (which it refers to as cognitive computing), security, and mobile. These segments have been hyped as strategic imperatives for the last few years but have still lagged competitors on nearly every front.

This doesn’t mean IBM is a lost cause. The company does have a very large salesforce and decades-old corporate relationships to leverage. Eventually, a tipping point will be reached where growth in the new segments with higher margins should offset falling profits elsewhere. Whether that point will occur soon, or a few years down the line is the million-dollar question.

 

Red Hat Unlikely to Contribute Anytime Soon

The bottom line is that Red Hat is unlikely to make a noticeable contribution to IBM anytime soon.

Last year IBM bought Red Hat, the largest ever acquisition of a software company. While the deal was struck in November, it only closed this week. IBM hopes that some of Red Hat’s products, notably OpenShift, will make the cloud offering more attractive to clients.

This will probably take time, as will Red Hat’s integration with IBM. The two companies have very different cultures which could create additional challenges. The bottom line is that Red Hat is unlikely to make a noticeable contribution to IBM anytime soon. Without organic revenue growth, there’s likely to be a much better opportunity later for long-term investors to buy into IBM.

 

All About the Margins

Investors are becoming impatient and skeptical, so forward guidance may be taken with a pinch of salt. In the interim, the clues will be in the margins. IBM doesn’t provide much transparency when it comes to different business segments. This makes it difficult to see how much each business is growing and what their contribution to the bottom line is. However, if or when, a tipping point is reached, the gross margin and operating margin should start showing sustained improvement.

The trailing 12-month gross margin has improved modestly in each of the last three quarters. The trailing 12-month EBIT margin looks like it may have bottomed in January last year. Quarterly margins look less convincing — both the gross margin and profit margin declined in the last quarter. These will be the key numbers for investors next week.

If earnings don’t start growing, IBM’s very generous dividend yield could be at risk too. IBM took on a lot of debt to pay for the Red Hat acquisition, and that debt needs to be serviced. Any improvement in margins will increase the probability that the tipping point has indeed been reached. But, without an indication of better times ahead, investors are likely to lose patience.