Who Says Elephants Can’t Dance?

This was CEO Lou Gerstner’s book title back in 2003 about bringing IBM back from the brink of insolvency to lead the computer business once again. When you look at IBM today, the last time revenue grew year-over-year was back in the March quarter of 2012. That is not a typo. 2012!

But we think the elephant may be starting to warm up its dance moves with a new partner, the Z14 mainframe. The Z14 has pervasive encryption which increases its cryptographic performance over the prior generation Z13 by 7 times due to a 4 times increase in the amount of silicon dedicated to this function.

Why does this matter? Yahoo recently admitted that all 3 billion of their accounts were hacked. More importantly Equifax, one of the nation’s three major credit reporting firms, announced the unauthorized accessing of Social Security numbers and birth dates of up to 143 million U.S. consumers. There are only roughly 325 million people in the entire US.

What is interesting is that of all the 9 billion data records that have been hacked over the last several years, only 4 percent of them were encrypted. If more had been protected by encryption, it might have deterred some of those hackers. After all, what use is getting a whole bunch of data if you cannot figure out what it means?

Do corporations care about the new IBM mainframe? Roughly half of IBM’s mainframe business is in financial services. IBM mainframes handle close to 90 percent of all credit card transactions ($7.7 trillion per year.) All of the 10 top insurers, 44 of the top 50 banks, 18 of the top 25 retailer and 90 percent of the largest airlines use IBM mainframes.

So what happened when IBM launched the new Z14 on September 13^th? IBM Z revenue grew 62 percent year over year in third quarter after being down 33 percent year over year in the prior quarter and systems hardware revenue was up 10 percent year over year in third quarter after being down 10 percent year over year in the prior quarter.

As a result, after missing revenue expectations in the prior two quarters, IBM beat revenues by close to 3 percent in the September quarter. This was the biggest beat since the June quarter of 2011.

Though we estimate IBM mainframe revenues are less than 5 percent of the company’s total revenues, customers buy software, services and storage as well that work with the mainframe. In total we believe that mainframes drive over 20 percent of IBMs total revenues and over 30 percent of IBMs total profits.

As for sentiment, it could not be much worse. Less than 30 percent of Wall Street analysts have a buy on the stock and over 10 percent have a sell. IBM’s stock is down 7 percent in 2017 in a raging bull market for all stocks but particularly technology stocks. As a result, IBM’s price to earnings ratio is a paltry 11 times versus the S&P at 20 times. IBM also has a dividend yield of 3.8 percent versus the S&P at 1.9 percent.

How risky is the stock in the event of a stock market sell-off? There are so few people left that are bullish on the stock that IBM was actually up on Wednesday when the S&P Information Technology Index declined about 3 percent and the FANG stocks declined 4 percent.

The 3.8 percent dividend yield is also very juicy with the S&P dividend yield at 1.9 percent and 10-year treasury yields at 2.4 percent. If we do finally get the long overdue correction in the second longest bull market since World War II, these defensive characteristics, much like on Wednesday, will become a lot more meaningful.

In summary, IBM may have had two left feet for the last 5 years, but we think their new dance partner, the Z14 mainframe, may get the elephant shimmying again over the next year.

Commentary by Dan Niles, founding partner of AlphaOne Capital Partners and senior portfolio manager of the AlphaOne Satori Fund. Previously, he was a managing director at Neuberger Berman, a subsidiary of Lehman Brothers.

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The views expressed are those of Mr. Niles and do not represent the views of AlphaOne Capital Partners, LLC, its portfolio managers, employees or affiliates. These views are current as of the time of this presentation and are subject to change without notice. This material is not intended to be a formal research report or recommendation and should not be construed as an offer to sell or the solicitation of an offer to buy any security. AlphaOne Capital Partners, LLC and its clients may have long or short positions in some or all of the securities discussed. Before acting on any advice or recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Mr. Niles does not accept any responsibility to update any opinions or other information contained in this document. Before acting on any advice, opinions or recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice.

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