BLUE NOTE

Front runners rejoice. There’s hardly been a better time to live at the top of the public company food chain, as evidenced by the rampaging performance of the behemoths of the S&P 500. Shares in Microsoft Corp., Apple, Inc., Amazon.com, Inc., Facebook, Inc. and Alphabet, Inc. have enjoyed gains ranging from 13% to 63% so far this year.  

The quintet now commands some 23% of the S&P 500’s index weighting according to Goldman Sachs, the highest proportion in the post-Bretton Woods era. The top dog, Microsoft, itself accounts for 5.9% of the S&P, approaching the record 6.4% weighting established by International Business Machines Corp. (IBM on the NYSE) in 1985.

Of course, trees don’t grow to the sky, and the law of gravity asserts itself sooner or later.  The Feb. 21 edition of Grant’s noted the thoroughly mixed investment record of companies that had ascended to that rarified air of index composition. 

Scale has its diseconomies as well as economies. At some invisible inflection point, the colossus loses more in dexterity than it gains in power and loses more in political vulnerability than it gains in commercial prestige. And at some other unmarked bend in the road, the once admirable founder of a great business may undergo the not unfamiliar personality transformation from entrepreneur to lord of creation.

What better example than IBM itself?  Since reaching that exalted status, the mainframe computer-turned-corporate consulting behemoth managed compound annual revenue and net income growth of 1.3% and 1.1%, respectively, in the 34 years through 2019, well below the average annual 2.6% rise in the CPI.  Since that Feb. 21 bearish analysis, shares are down by 14% inclusive of dividends (trailing the 2% decline in the S&P 500), and now represent just 0.4% of the broad U.S. stock index. 

On Monday, Big Blue reported second quarter revenues of $18.12 billion, topping consensus estimates of $17.6 billion but 5.4% below the year-ago figure.  The company trumpeted 30% sales growth among its cloud computing units, helped by the July 2019 acquisition of Red Hat for $34 billion.  The newcomer made a strong first impression, as Red Hat managed 17% revenue growth compared to the second quarter of 2019. 

The Street cheered the report, with a host of brokerage houses raising price targets.  Analysts at Argus Research upgraded IBM shares to “buy,” declaring: “We believe IBM has turned an important corner.”  The valuation seemingly leaves plenty of room for improvement, as shares fetch less than 12 times full-year earnings per share estimates. 

Then again, that undemanding multiple reflects the fact that IBM’s non-cloud businesses are in chronic decline, as the global business and technology service units (which account for more than half of total revenues) saw their top lines shrink by 7% and 8%, respectively.   Excluding the $900 million contribution from Red Hat, total revenues of $17.2 billion would have declined more than 10% from last year.  As the deal was completed last July, IBM will now face tougher, apples-to-apples comparisons in coming quarters. 

Grim growth prospects color a now less-than-pristine balance sheet. Thanks to that Red Hat deal (for which IBM paid 10 times revenues, 53 times Ebitda and a 63% premium to the target’s pre-bid closing price), single-A-rated IBM’s net leverage has risen to 3.3 times trailing Ebitda from the 1.5 times Ebitda prior to the deal announcement.  While the company suspended share buybacks last year, management has signaled it expects to continue paying its $1.63 per share quarterly dividend, which equates to a relatively chunky 5.1% indicated yield.  The $1.45 billion in dividend payouts amounted to roughly half of free cash flow generated during the quarter. 

Indeed, IBM’s post-1985 travails should serve as a cautionary tale for the modern-day high fliers. Bloomberg reports this afternoon that a House antitrust panel is set to meet July 27 with an eye towards scrutinizing Amazon, Facebook and Google, while Italian antitrust authorities announced their own investigation into Apple and Amazon yesterday. In addition, Axios relays that a coalition of state attorneys general “are investigating Apple for potentially deceiving consumers.”

Reserve Bank credit (the sum total of interest-bearing assets at the Fed) rose slightly to $6.91 trillion, up $30 billion from last week’s reading.  That breaks a five week streak of declines, but the rate of growth continues to slow to a 72% three-month annualized pace,  down from 124% last week and 540% a month ago. 

Risk aversion was the name of the game, as stocks came under pressure with the S&P 500 slipping by 1% to finish back near the unchanged mark year-to-date, while a strong rally in long dated Treasurys pushed the 10-year yield below 0.58%. Gold continued its aggressive rally with a move to $1,881 an ounce, WTI crude remained at $41 a barrel, and the VIX rose 7% to 26. 

– Philip Grant

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