Big Blue's Big Bounce, and What Blew Housing Starts Down in September

In this Market Foolery podcast, Chris Hill, Jim Mueller of Stock Advisor and Motley Fool Options, and David Kretzmann of Motley Fool Rule Breakers and SuperNova consider just what in its quarterly report caused investors to bid IBM (NYSE: IBM) shares up 9% in a day. They also discuss the unsurprising news that U.S. housing starts were seriously dented by Harvey and Irma -- though not just by the hurricanes. And they dip into the mailbag to answer a couple of questions about always-exciting Amazon.com (NASDAQ: AMZN) and rarely mentioned 3M (NYSE: MMM).

A full transcript follows the video.

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This video was recorded on Oct. 18, 2017.

Chris Hill: It's Wednesday, Oct. 18. Welcome to Market Foolery. I'm Chris Hill. Joining me in studio today, from Rule Breakers and Supernova, David Kretzmann, and from Supernova and Motley Fool Pro and Options, Jim Mueller. Happy Wednesday, gents!

Jim Mueller: Hey, Chris!

David Kretzmann: Hey, Chris!

Hill: Happy Black Monday anniversary eve!

Kretzmann: Is that the day?

Hill: Well, tomorrow. As I look at Kretzmann, I'm confident that you weren't even born, but yes.

Kretzmann: Yeah, I had no idea what you were talking about. Is that a holiday?

Hill: Jim and I know.

Mueller: I recognized the reference, but I didn't realize it was this week.

Hill: Yes. Tomorrow, Oct. 19, is the 30th anniversary of Black Monday.

Kretzmann: Got it. Now I'm on the same wavelength. It took me a little while.

Hill: I'm sure you read about it in a book somewhere.

Mueller: In a history test. [laughs]

Hill: We're going to dip into the Fool mailbag. But we have to start with Big Blue. Holy cow. IBM, despite the fact that IBM's streak is intact, and when I talk about IBM's streak, I'm referring to -- this is the 22nd consecutive quarter of falling revenue for IBM, and somehow, David, shares of IBM, up 9% today. What's going on here? First of all, they could have had an amazing quarter. They could have broken the streak, and I still wouldn't have expected the stock to be up 9%.

Kretzmann: Yeah, I think in this case, it's just, low expectations can be a wonderful thing for a stock in the short term. In general, this is a similar story for IBM. You have what's really been a struggling legacy mainframe hardware and software business, trying to transition into the age of artificial intelligence with Watson, cloud computing, things like that. So they are continuing to see some progress with their strategic imperatives, so you know it's important. [laughs] Those are their new businesses like cloud computing --

Hill: Wait. Please tell me that that's a name of one of their business units.

Kretzmann: That's all their up-and-coming important businesses. Cloud computing, artificial intelligence, Watson applications, things like that. Kind of all the new sexy stuff. For this quarter, strategic imperatives, all those different segments and businesses grew 11%. So, not knocking the cover off the ball, but it's at least growing. It's not dropping. And that segment now makes up 45% of total revenue, so it's getting closer and closer to a tipping point where you could see the company returning to growth, and hopefully they can end that unfortunate streak of 22 straight quarters of sales declines. Their cloud revenue, narrowing in on that, was up 20%. But in general, even with that growth of strategic imperatives, they're still seeing their margins decline. But the pace of the decline is slowing. If you want to find a silver lining there, that could be one.

I thought it was interesting to take a step back and compare IBM and Microsoft (NASDAQ: MSFT), because back in 2009 or so, these companies were about the same size, about $150 billion market value. They're producing roughly $16 billion in free cash flow. That was back in 2009. Eight years later, today, IBM is producing less free cash flow, less than $13 billion in free cash flow. Microsoft, over $31 billion in free cash flow. IBM's market cap today is still around $150 billion. Microsoft had a nice $600 billion.

So you can just see the trajectory of those businesses, which were in similar positions, where they had a legacy business that was producing a lot of cash. But both of them missed the initial transition to things like mobile, cloud computing, artificial intelligence. Microsoft, under the leadership of Satya Nadella the past few years, has really had a resurgence in a huge way, but IBM is still trying to figure out its identity as these new initiatives grab hold. But it seems like, with those strategic imperatives moving in the right direction, there's still reason to be optimistic that IBM's worst days aren't necessarily ahead yet.

Hill: It's a great point about Nadella, because when he was brought in to replace at-the-time longtime CEO Steve Ballmer, there was not necessarily any reason to expect the type of performance we've seen over the last few years from Microsoft. And I think it is an indication of how important leadership is. It's still, with IBM, a $150 billion business. They still have plenty of things that they can do. And maybe, if they get the right leader in there, that's the catalyst to move things along.

Kretzmann: Yeah, I think it's a company that can still be relevant. But like I said, I think they're still struggling to find their identity. At this point, they're spending more each on dividend payouts and stock buybacks than they are on capital expenditures. They're basically sending more money out to shareholders than they're investing in the business. I think, in a case like this, where you really do need to be investing to be on top of these emerging trends, I would hope they would prioritize their capital expenditures a bit more. But they still have a lot of cash. They have a lot of levers they can pull. So I can understand, given the low expectations, why the stock is popping a bit today.

Hill: Nine percent, though.

Kretzmann: That's a lot. But looking at the past couple of years, it hasn't been a pretty story for IBM.

Hill: Again at some point, in the next, say, conservatively, five years, I would bet that they break this streak. And what a party it's going to be then.

Kretzmann: Hey, something to look forward to.

Hill: Monthly housing starts in September came in lower than expected. U.S. homebuilding fell to a one-year low. Although, Jim, we were talking before we started taping, I'm not entirely sure why this is a surprise when you consider the impact of the recent hurricanes.

Mueller: Right. The numbers were, September housing starts came in at 1.127 million. But the expectations were for 1.18 million. And as you said, a one-year low. So that's down about 4.7% nationwide. But in the south, where those hurricanes hit, in Texas, that's a big area, Florida is a big area, the downdraft was 9.3% for those. And that's to be expected, because about half of homebuilding in the nation is down in the South. I follow Meritage Homes, a recommendation in Stock Advisor and Options. They've been saying that construction is already tight. They've had labor issues for years, basically since the housing bubble popped. All the skilled workers were laid off, and of course they had to go find other jobs. Now that the recovery is well in place, there's not the big labor pool that homebuilders need. And that's been keeping the starts down. It's been keeping prices high, because supply is constrained.

Hill: Have they thought about paying people more money? [laughs]

Mueller: They do, but it takes a while to become skilled plumbers, electricians, all these different skilled labors that you need to build a home, especially the modern homes, the green homes, the ones that are well wired for internet and all that other stuff. And now, with all the reconstruction that's going to have to be going on in Houston and Miami and points west from there and even out in Puerto Rico and the Virgin Islands, labor is going to get even tighter. With an administration that is not too happy with immigrant labor, and where an industry has anywhere between 13% and 25%, depending on how you're counting, immigrant labor, this is going to probably be a multi-year issue, I think, certainly multi-quarter, for housing.

Hill: Do you agree with that, David?

Kretzmann: Yeah, I think so. It's interesting. Take a step back and think about which industries will be negatively impacted by this, and some industries will actually do pretty well. Looking at total retail sales in September, they actually grew 1.6% from August, and that's the highest increase we've seen since March 2015. It looked like that was primarily due to consumers purchasing cars, gasoline, and building materials, especially in the Houston and Miami areas. You see some companies, like CarMax (NYSE: KMX), the used-car retailer -- the stock is up over 16% since Hurricane Harvey hit in mid-August. Yeah, I think you'll see some companies, like the car dealerships, retailers, will probably see a nice short-term boost in business, anyway. I would think Home Depot and Lowe's would do pretty well as this rebuilding effort continues. That should be a boon at least for the next few quarters.

Hill: So what should investors expect in terms of the earnings season that is going to kick into high gear over the next few weeks, in terms of companies citing the hurricanes? Obviously, as you indicated, Jim, particularly when you're talking about housing and how dependent it is on the South and Southeast United States, that makes perfect sense. I'm also very confident that there are going to be some companies that cite the hurricanes that will leave investors scratching their heads saying, wait a minute, really?

Mueller: About the only company that I think won't be doing that is Weyerhaeuser, which is up in the Pacific Northwest.

Kretzmann: They're safe.

Mueller: But everyone else. Restaurants are going to cite it. Regular retail, not housing-related retail like Lowe's and Home Depot, but regular retail, maybe even affecting the Christmas shopping season, where people are having to spend to rebuild and restock their houses rather than buy all the toys and gifts. So yeah, this will be a while.

Kretzmann: Yeah. One company that I would expect will mention the hurricanes quite a lot would be Chuy's. It's a small-cap restaurant that started in Austin, but they have a heavy concentration in Texas, including Houston. I think, when you have a heavy concentration in that region, and you're a restaurant which has already been struggling the past couple of years, this won't help.

Hill: Well, in the case of restaurants, obviously, you're looking at revenue that's never going to come back, because you can fix up your restaurant and open it, but people aren't going to eat twice as many meals just to make up for that, whereas --

Kretzmann: Speak for yourself, Chris.

Hill: [laughs] But, with auto dealers, with car manufacturers, those are purchases that are seemingly just delayed or pushed off a little bit.

Mueller: Delayed, or even addition. If you have a car that you were thinking of replacing, but were willing to wait another year or two --

Hill: And now it's submerged.

Mueller: -- and now it's submerged or was submerged. So a lot of those have possibly been pulled forward into the next couple of quarters. So that might affect those companies further down the road.

Hill: Question. Matt Clemente -- and this dovetails off of our conversation yesterday about Netflix (NASDAQ: NFLX). Matt asks, "What if Amazon broke out not only the video streaming, but also music streaming as a combined separate service for, say, $10-$15 a month?"

For those who missed yesterday's episode, this was, Seth Jayson and I were talking about Netflix's latest quarter, and I made the point that, I look at Netflix and see a business that, over the next two years, is in really great shape. For whatever people may think of the valuation of the stock, not to say that they can't be disrupted five years from now, but I think over the next couple of years, they're in really great shape. You get some analysts hypothesizing this type of thing, and the example I used yesterday was Amazon. One analyst was like, what if Amazon breaks out Amazon Prime video streaming for just $7 a month? It's like, yes, that's a possibility, but until that actually happens, why don't we just hold off on that. [laughs] Before we get all twitterpated about that.

But I don't know, Jim. To Matt's question, when you think about competition for Netflix, where do you think things stand right now, and how much of a threat do you think that type of thing would be from Amazon?

Mueller: I think it would help Amazon more than it would hurt Netflix. Amazon Prime video is buried within the Amazon ecosystem. There's Amazon, there's Amazon Prime, there's Amazon Video, there's Amazon Prime Video. You're using Amazon Video to watch Amazon Prime Video. When you go searching for a movie -- I just did it this morning. I ended up with DVDs instead of Prime Video. [laughs] So there's a branding issue that Amazon needs to fix. And if they broke that out, the streaming service, and tied it with music, I would probably buy it. I'm a subscriber and shareholder of both companies. Prime member, I guess.

But as for competing against Netflix, they already compete. It might make things a little more clarified and a little more focused for Amazon and Prime Video to have a business unit focused exclusively on that rather than as an adjunct bonus for being a Prime member. But not anytime really soon, being really serious. According to Sandvine, the last numbers in 2016, Netflix accounted for 33% of the primetime downloading, down-streaming, and Amazon Prime just 4%. So it'll be a while before they become a serious competitor.

Hill: And we've talked about this before. This is not like buying a car. This is not like buying a house. This is a situation where it's perfectly reasonable to expect people will have multiple streaming services.

Kretzmann: Yeah. It was actually last year when Amazon announced they would be offering Prime Video as a standalone subscription offering at $9 a month. I don't know if that's still active, or what actually happened with that. But they did offer that. And the funny thing about it is, $9 a month over the course of a year, that would end up costing more than the $99 subscription for Prime, so if you're buying that, why don't you just buy Prime?

I think one advantage that Netflix continues to have in the streaming space is, they are truly global today, and no one else comes close to the global scope that they have. Netflix is now in over 190 countries. So they're getting that data, they're getting the habits, they're understanding the habits, the usage of all these users around the world in those different regions. And that data will increasingly be helpful for them as they try to figure out what content they want to invest in. For other companies that are stumbling a little bit more through a few different regions, not really on a global level, I think it's a little bit more of a shot in the dark with content.

I think, to Netflix's credit, they have had a stronger record of producing hits compared to Amazon. Amazon, obviously, has received its fair share of awards and things like that, but they haven't had the megahits that Netflix has pretty consistently been able to churn out every year. So I think that global data advantage will continue and probably even accelerate for Netflix, because they're the only company operating on that scale, and I think it'll be a while before Amazon or someone else really matches them there.

Mueller: Amazon is international. They are in Europe as well. But David, you're exactly right. Netflix has been collecting this data for years and years, and they have a big head start, and that's really helping them figure out what content to go after and what content to produce. Amazon will catch up, or will get more and more data, as they do more and more of this, as will Hulu and as will Disney when they launch their thing. But Netflix has a big lead in that department.

Hill: I totally understand why any company would keep information private, particularly when it comes to their membership base and all of the day that they have. That being said, I genuinely appreciate that Netflix, as they have spread across the globe, I love that they are sharing country by country what shows are really popular. For example, learning that -- and Jim, we've talked before about how, over the last few years, as they have expanded internationally, they have done a very good job of going to show-runners in different countries and producing shows that are native to the country, native to the language, that sort of thing. But the fact that, for example, in Ecuador, the most popular show in terms of streaming Netflix is Fuller House. That's just delightful to me. The Defenders, the Marvel series which I greatly enjoy --

Mueller: I've heard that Adam Sandler is really popular outside the U.S.

Hill: Is he? Tom Cruise certainly is.

Mueller: Oh, yeah, at least according to Netflix.

Hill: The Defenders is the No. 1 Netflix show in [South] Korea. Anyway, I appreciate that they show that stuff.

One more mailbag question from, I don't know this person's name, it was simply pistolcell@aol.com. "Would you guys recommend 3M as a buy-and-hold-forever stock?" 3M, are they a Dividend Aristocrat?

Kretzmann: I think it is.

Hill: It's pretty darn close if it's not already. But 3M is one of those boring stocks that also does really well. Just over the past decade, it's more than doubled the market's performance. Probably best known for Post-it notes, although they do --

Kretzmann: Scotch tape.

Hill: Scotch tape, so many different things. I don't know if it's a buy and hold forever, but let me it throw to you guys. Jim, what do you think?

Mueller: 3M, they're very big in the research-and-development field. And I think they make it a point of having a third to a half of their sales from products that they've developed and launched in the last few years. So they're very dynamic. They're just not resting on their lawyers -- their laurels, sorry. Well, not their lawyers, either.

Hill: Every company of that size is resting on their lawyers to one degree or another.

Mueller: Of having Post-it notes. I think the way the question is framed, buy and hold forever, I don't think any company is a buy and hold forever, and never sell. You do have the stories of buy and hold for years and years and you turn a few thousand dollars into a few million dollars. That's fantastic, and I'm hoping to do that with Netflix myself. But, there are times when it makes sense to sell a company. 3M is a decent candidate. I have another company in mind -- Rollins. That's not familiar under that name, but if I say Orkin, you'll recognize the company.

Hill: That's right.

Mueller: They're the pest-control company, with Orkin and several other brands. One of the great lines their CEO says is cockroaches don't read The Wall Street Journal. So by that he means, it's a very recession-resistant company. They've grown both revenue and earnings year of year on quarters for, I think, 45 consecutive quarters now.

Hill: So, the opposite of IBM.

Mueller: [laughs] Right.

Kretzmann: That's the direction to be going.

Mueller: They raised their dividend, they have a 1.2% yield, and they've raised the dividend for 10% or more for the last 14 years. So maybe not a stock aristocrat or Dividend Aristocrat, but they're headed that way.

Hill: Nice. David, what about you? If it's not forever, what's a stock that has a really long horizon in your mind?

Kretzmann: To the point about 3M, I think something that's appealing there is, they're operating on a global scale, they have a lot of repeat sales, and basically, as the economy grows, 3M will very likely grow for a long time.

I think another company that fits into that is Starbucks. They're actually opening 12,000 new stores by 2021. That's their goal. So by that point, if they hit that mark, they would have over 37,000 stores globally. They think one day China will exceed the U.S. in terms of store count. Right now, the U.S. has over 13,000 stores. China has about 1,300 stores. Obviously, a lot of room to grow there. They're getting more into tea, iced beverages, food, a lot of different levels they can pull across an incredible retail restaurant business globally. And it doesn't hurt that caffeine is legally addictive. People keep going back for more.

Mueller: [laughs] Don't I know it.

Kretzmann: And the nice thing, when you look at these kind of companies that you would feel comfortable buying and holding for 20-plus years, ideally longer, is that as they grow and increase cash production over time, the dividend will increase along the way. Or at some point, if a company is not necessarily paying a dividend today or much of a dividend today, that dividend could one day potentially, you could be receiving more cash in the form of a dividend than your original position that you bought. So that can become a very powerful compounding multiplier over time, when the dividend you're receiving exceeds the initial price you paid to buy the stock.

Mueller: If you reinvest those dividends in more shares of the stock.

Kretzmann: That helps, too.

Mueller: Yeah, that's how that works inside of the human lifetime.

Hill: Yeah. Check that box.

Kretzmann: I didn't get one of those. Sysco, not the data company but the food distribution company --

Hill: Sysco with an "S." Not Cisco Systems.

Kretzmann: If you had bought shares of them in 1975 and held them to today, I think the dividends you would be receiving today would be double the price you paid for the stock at that point. Just an incredibly powerful force, when you can find a company like that and hold it over decades, which is obviously what we're all trying to do here. It's a long time horizon, but if you can be patient, hold great companies for a very long time, it can be a really powerful effect.

Mueller: There's lots of companies like that. Coca-Cola has that. Altria-slash-Philip Morris has that. 3M is a great company. I'm not saying don't buy it or don't hold it. But there are others out there, as well.

Hill: Original name is Minnesota Mining and Metal?

Kretzmann: Mining and Minerals, I think.

Mueller: Minnesota Mining and Manufacturing.

Hill: Manufacturing, there you go. You know what? 3M.

Kretzmann: They changed it to that for a reason.

Hill: [laughs] At some point, someone said, you know what? Kind of like, at some point, someone at the National Biscuit Company said, can we just shorten this to Nabisco and move on? And they did. All right, Jim Mueller, David Kretzmann, thanks for being here!

Mueller: Thanks, Chris!

Kretzmann: Thanks, Chris!

Hill: As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. That's going to do it for this edition of Market Foolery. The show is mixed by Dan Boyd. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.

Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool's board of directors. LinkedIn is owned by Microsoft. Chris Hill owns shares of Amazon. David Kretzmann owns shares of Amazon and Netflix. Jim Mueller, CFA owns shares of 3M, Amazon, and Netflix and has the following options: short January 2018 $150 calls on IBM, long January 2018 $135 calls on IBM, short January 2018 $135 puts on IBM, and long January 2019 $110 calls on Netflix. The Motley Fool owns shares of and recommends Amazon and Netflix. The Motley Fool recommends 3M. The Motley Fool has a disclosure policy.