[Raising comment @10b4jZsf-1nzs to a standalone post].
Once Red Hat is integrated, I expect IBM to leverage Red Hat's SG&A and R&D infrastructure. This
should allow the company to cut expenses further while benefiting from Red Hat's outsized growth in
the hybrid cloud space. IBM could move the needle with big expense cuts. This is why IBM bulls could
be so excited about the stock.
https://seekingalpha.com/article/4276868-ibm-levers-pull
In its most recent quarter, IBM (IBM) reported an EPS beat, but missed on revenue by $40 million. The stock is up nearly 5% post-earnings. I had the following takeaways on the quarter:
Red Hat's Revenue Impact Will Be Negligible ...
I have been an IBM bear for a while. The company has been transitioning from mainframe computing to cloud computing. Its legacy business has been winding down, while cloud revenue has been growing rapidly. Revenue from IBM's legacy business has been cascading downward, causing total revenue to fall. The new narrative surrounds its acquisition of Red Hat, and this has likely gotten investors excited.
The following chart illustrates IBM/Red Hat pro forma revenue growth. IBM's Q2 2019 revenue of $19.2 billion was down 4% Y/Y. Including Red Hat's most recent quarterly revenue of $934 million, pro forma revenue would have been $20.1 billion, down 3%.
Revenue from Cloud & Cognitive Software was up 3% on growth in cloud and data platforms and cognitive applications. Global Business Services ("GBS") revenue was flat, but the segment did gain traction in some of the consulting services offered by IBM. The other IBM segments experienced declines. Global Technology Services ("GTS") is the largest segment at 34% of pro forma revenue. The company is managing the business for increased margin, profit, and cash contribution. This could hurt revenue growth, yet lead to improved margins.
Red Hat's revenue grew by double digits in its most recent quarter. Its hybrid cloud offerings could make IBM one of the top players in hybrid cloud computing. For now, Red Hat would represent about 5% of IBM's pro forma revenue.
IBM Has Levers To Pull
IBM's revenue continues to decline, yet its margins are improving. Its gross margin was 47.0%, up 100 basis points versus the year-earlier period. Gross profit on a dollar basis fell 2% to $9.0 billion; its decline was less than the decline in revenue. The company has been trying to shift more revenue to higher margin hybrid cloud and AI. This could lead to expanding margins over the long term. Management has also been trying to make the remaining business lines more profitable.
GBS gross margin was flat, yet the segment continued to change its business mix to higher-value offerings. GTS gross margin expanded by 120 basis points. This is important, as it represents IBM's largest business segment. SG&A and RD&E expenses were a combined $6.9 billion, up 10% Y/Y. However, management made deep cuts to other expenses. Total expense and other income was $6.2 billion, down 3% Y/Y. Income from continuing operations to remain demonstrating flat growth, despite the decline in revenue.
Once Red Hat is integrated, I expect IBM to leverage Red Hat's SG&A and R&D infrastructure. This should allow the company to cut expenses further while benefiting from Red Hat's outsized growth in the hybrid cloud space. IBM could move the needle with big expense cuts. This is why IBM bulls could be so excited about the stock.
Red Hat Will Come At A Cost
IBM raised $20 billion in additional debt to fund the Red Hat deal. It had total debt of $73 billion at Q2 2019, up from $50 billion at Q1. Increased operating income from Red Hat and improved margins from IBM must offset the increased interest expense from the additional debt. Otherwise, the company could be running in quicksand. Moody's recently downgraded IBM's debt from A2 to A1 with a stable outlook. Outsized growth in the hybrid cloud space is not a certainty. However, increased interest burden from rising debt is practically a certainty.
If the Red Hat deal does not materialize as expected due to execution risk, a weak economy or some other reason, IBM could have trouble servicing its debt. A dilutive event to pare its debt load could become a viable option.
Conclusion
Cost take-outs could drive bottom-line growth for IBM. The stock is up 3% Y/Y. I rate IBM a hold.