Shares of International Business Machines (IBM) have declined by 8.9% from its 52-week high of $211.79 attained in October 2012. At $192.88, the stock is currently trading at around the mid-point of the 52-week trading band and offers a dividend yield at 1.8%. Has the recent pullback created a buying opportunity? In this article, I will walk you through my stock value analysis which may assist you in formulating the investment decisions.
From a relative valuation perspective, IBM's current valuation appears to be reasonable based on the firm's solid financial performance relative to its peers (see comparable analysis chart below). Sell-side analysts on average predict the firm's revenue, EBITDA, and EPS to rise by 2-year CAGRs of 2.7%, 7.7%, and 9.8%, respectively, over the current and next fiscal years. Those consensus growth estimates underperform the averages of 6.0%, 6.5%, and 11.8%, respectively, for a peer group consisting of IBM's primary competitors. However, IBM's EBITDA margin is forecasted to expand by 2.5% over the same period, compared to an average estimate of just 0.7% for the comparable companies. On the profit side, IBM has demonstrated a superior profitability as most of the firm's margins are above the par. In addition, the firm's capital return metrics including ROIC and ROE are considerably higher than the peer averages. In terms of leverage and liquidity, IBM assumes a relatively higher level of debt as reflected by the firm's above-average debt to capitalization and debt to EBITDA ratios. The company's trailing free cash flow margin is below the par, but remains at a solid level. Due to the strong profitability, IBM was able to maintain a healthy interest coverage ratio. However, both the firm's current and quick ratios are below the par, reflecting a mediocre balance sheet performance.
To summarize the financial comparisons, IBM's relatively weaker growth potential appears to be the primary drag on the stock's valuation. However, given the company's superior margin and capital return performance, significant portion of recurring revenue, as well as its strong global presence, I believe the stock should be fairly valued at a slight premium over the peer-average level. The current stock valuations at 8.4x forward EV/EBITDA and 11.9x forward P/E represent an average valuation premium of 10.6% over the peer-average trading multiples (see chart above), suggesting a fair stock valuation.
A similar conclusion can also be drawn from a historical standpoint. IBM's trailing P/E multiple of 13.7x is currently trading at 14.0% discount to its 10-year historical average (see chart below). I believe this represents a reasonable valuation level provided that 1) IBM's estimated revenue, EBITDA, and EPS growth rates have trended down markedly over the past 10 years; 2) despite the lower growth, the company's capital return metrics including ROA, ROIC, and ROE have grown significantly over the same period; 3) the firm's various margins have also been expanding steadily over the period; and 4) IBM has seen only a slight increase in the leverage since 2002 (see charts below).
To support my view, I also performed a DCF analysis which incorporates the market's consensus revenue and EBITDA estimates from fiscal 2013 to fiscal 2015 (see DCF chart below). Other free cash flow items including depreciation, tax expense, capital expenditure, and net working capital investment are projected based on their historical figures relative to the revenue as those ratios have been trending steadily over time. Annual revenue in fiscal 2016 and 2017 are assumed to grow at the average estimated revenue growth rate from fiscal 2013 to fiscal 2015, and the terminal revenue growth rate is set to be 2.0%, which is close to the rate of inflation. Annual EBITDA in fiscal 2016 and 2017 is forecasted by setting the EBITDA margin to be the average margin from fiscal 2012 to 2017, and the terminal EBITDA margin is also assumed to be the same.
A company-specific risk premium of 2.5% is used in the cost of equity calculation to account for the financial projection risk. Instead of using the currently depressed 10-year US Treasury Bond yield, a normalized 10-year risk-free rate is applied. As such, based on a WACC of 9.5%, a terminal growth rate of 2.0%, and an implied terminal EBITDA multiple of 7.9x, the DCF model yields a stock value of $200.26, which is 3.8% above the current share price of $192.88 and thus indicates that the stock is reasonably valued.
Sterne Agee's research analyst, Shaw Wu, elaborated on his medium-to-long term bullish view on IBM in a recent research note (sourced from Thomson One, Equity Research):
"We believe one of the most important lessons in recent years is that it is much more difficult than consensus thinking to replicate IBM's unique business model where it combines hardware, software, and services and broad geographic reach in addressing the enterprise market. Many companies have tried to replicate IBM without much success and we think this helps prove that replicating IBM is not easy…the part we think is often overlooked is the product cycle catalyst side to the IBM story that is driven by its hardware business. In the past, we have seen new Power and PowerPC processors help drive new server sales, which have in turn helped drive associated software and services. The last big refresh was in February 2010 when Power 7 servers shipped with IBM shares around $120-$125 per share. We believe this helped drive accelerated revenue and EPS growth and hence a higher stock price where shares nearly doubled to $200 in February 2012 following a 2-year cycle. We believe Power 7+ could help drive a similar impact."
Lastly, according to a chart shown below, IBM has been distributing out almost its entire annual free cash flow in the form of dividend and share repurchase over the past years (see chart below). Given the firm's solid prospects, I expect IBM will continue to generate significant free cash flows and return capital to shareholders, and this would likely offer a strong support to the stock price over time.
In conclusion, given IBM's solid growth prospects, steady financial performance, as well as its shareholder-friendly dividend and share repurchase policy, I believe the stock represents a quality long-term investment. As the current valuation does not appear to be cheap, to limit the investment risk, investors could sell out-of-money put options to either collect premium upfront or take a potential opportunity to acquire the shares at a lower price.
The comparable analysis and DCF charts are created by the author, all other charts are sourced from Capital IQ, and all historical and consensus estimated financial data in the article and the charts are sourced from Capital IQ unless otherwise specified.
Disclosure: I am long IBM.