1) IBM has a large financial service business. First, it affects financial variables such as FCF. (The company provides selected figures of ex-financials figure, but it does not look like all are using it) Second, it represents the challenges of migration from the proprietary system & middleware WITH associated one-stop shop model to the application (BI) software cloud service oriented model.

2) First, separate financial analysis and valuation are necessary, but not all seem to be paying attention. Detailed information of IBM Credit LLC is disclosed in the filing and the presentation. Use those and look at FCFE ex-financial service. Whatever valuation model you use, it is a right starting point, and unadjusted valuation multiples, for instance, is not a good measure. (as is the case for GM)

3) Second, financial service has very high ROI which tells how IBM generates total profits from the lifecycle of IT asset. In other words, the integrated one-stop shop of service enabled IBM to get high cash flow out from the transaction. IBM sells hardware (MF or x86server) and middleware (WebSphere) as a bundle, then add IT service of software integration and maintenance come with it, on top of financial (lease) and used equipment sales. However, if software goes to the cloud and becomes service, on-premises middleware and application & system integration are not required.

4) So from the investment perspective, the certainty of future cash flow rests on the prospect whether, post the cloud era, IBM can structure its business model and financial model that are comparable to the one that they had before the cloud era.

5) To be fair, I think – although it is not a shiny business – IBM still dominates high-performance and high-reliability computing system. The mainframe, although very expensive and cyclical on product refresh cycle, is very unlikely to get replaced with Apache servers on premises or as a highly scalable cloud service, especially for mission critical (super-fast I/O) & secure financial transactions. This will not change over the extended period. IBM is the strongest remaining survivor with the largest installment base. The certainty of positive cash flow from this business model is high. As described, they have a structured one-stop shop system for this product as well. Blockchain and the renewal of Swift system would be a potential opportunity – if it materializes. They will secure the certainty even more. This certainty is, however, given as a basis and other parts of business should determine the judgment of risk.

6) The management states that new business is driving and profit will grow at mid-single digit, faster than revenue. The management made acceleration of M&A recently to complement the innovative technology to turn toward growth, as old technology is on the decline. As a result, its financials are showing the direction they have been heading to as well as the progress so far. Software booking growth is still weak. GBS IT business has been declining for some time. Goodwill/Equity ratio is elevated and becomes even higher for ex-financials. Financial service total asset is on the decline. Check those figures. The company focuses on strategic imperatives as a key but unlike Adobe or business application of Microsoft, which had a simpler conversion from desktop to cloud, IBM’s migration is not only a simple conversion to the online application (to that extent I do not think Adobe cloud is a real cloud-oriented app). Also, It is not taking place for the products with a sticky and dominant market position.

7) Another variable that I did not mention is Cognitive Solution including Watson analytics. Remember IBM has Cognos and Watson and Cognos is much bigger at present. Watson has an interface that appeals a wider range of the user base, and given how IBM present it, it gives the financial community the impression that Watson is a key revenue leading product, but I think the migration of Cognos matters more financially. As the underlying architecture is different, I am not sure if and how Cognos will evolve and if it will be combined with Watson that currently does not have in-depth integration.

8) On hardware, Power9 chip for data center servers. It is competing with Intel, and there are cloud vendors that are getting interested in Power9, – a great opportunity, but it is too early to call its trajectory or certainty.

9) I would like to leave the judgment to readers, but as every invest does, IBM has unique uncertainty. Taking such uncertainty into account, discounting it, and getting a range of certainty equivalent cash flow would give you a better idea.

10) The key message here is that fundamental buy-side investors and analysts need to figure about certainty carefully as the key result of subjective judgment. Using the right financial metrics and valuation equation incorporating such views is also a key.

11) If you are not sure about its certainty of fundamental return of FCF, (not the certainty of price appreciation) after checking fundamentals very hard, you do not need to work on detailed valuation because you are doing what you think unreliable at best. Just focus on what you think you can do well consistently. Evaluating and eliminating uncertainty and focusing on selected stocks is done only through the very careful subjective process, which is where fundamental investors should be paying attention at the highest level. As Michael Porter said, The essence of strategy is choosing what not to do – a virtue as well as challenging luxury of implementation for fundamental buy-side investors/analysts.

12) The skill & implementation of the successful trading idea is not the same as the skill & management of fundamental investment process. To judge certainty in a constant manner requires careful self-awareness and persistent composure.

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