Despite the fact that management artificially inflates earnings per share, International Business Machines Corp. (NYSE:IBM) is a fantastic company that makes a lot of money. I believe IBM is likely to continue to make a lot of money for a very long time. I also believe the current market price of the company is well below its intrinsic value. In a nutshell, IBM is a great investment.
What Does IBM Do?
IBM basically implements business and technology solutions for its clients. According to IBM's annual report, "the company creates business value for clients and solves business problems through integrated solutions that leverage information technology and deep knowledge of business processes" (p20 annual report). As an example of the type of work IBM does, "Mazda Motor Corporation collaborated with IBM analytics, data modeling and traffic simulation experts to reduce human error in driving. The result was an early warning system using IBM analytics software that identifies accident-prone areas, warns drivers of danger and learns as conditions change." (p13 annual report). As another example, "Guangdong Hospital of Traditional Chinese Medicine worked with IBM Research to understand the effectiveness of traditional Chinese and Western treatments of chronic kidney disease. IBM information management and analytics software helps the hospital correlate patient information with demographics, such as age and gender, and relevant anonymized cases to improve outcomes, boost quality of care and reduce costs." (p13 annual report).
IBM divides itself into five business segments:
1) Global Technology Services (GTS) is the largest segment with roughly 38% of IBM's $106.9 billion in total revenues and a healthy 35% gross margin (annual report p26). GTS provides IT infrastructure services and business process services (annual report p22). GTS is a services-based segment, and I believe services business will be the main source of IBM's future profitable growth.
2) Global Business Services (GBS) provides 18% of IBM's total revenues and has a 29% gross margin (annual report p26). GBS provides professional services and application management services (annual report p23). GBS is also a services-based segment, and I believe services business will be the main source of IBM's future profitable growth.
3) Software provides 23% of total revenue, and has an impressive 88.5% gross margin (annual report p26). Software consists of middleware and operating systems software (annual report p23). While Software provides significant revenue and impressive gross margins, I believe this segment has grown mainly inorganically (through acquisitions), the margins will decline, and this will not be the main driver of future IBM growth.
4) Systems and Technology delivers 17.8% of total revenue with a 39.8% gross margin (annual report p26). Systems and Technology provides clients with business solutions requiring advanced computing power and storage capabilities (annual report p24). This is largely a legacy segment, it has not grown significantly in the last decade, I don't expect it to grow significantly in the future, and I do not expect it to drive future growth for IBM.
5) Global Financing (and other) provides about 3% of total revenue and has a gross margin of around 50% (annual report p26). Global Financing invests in financing assets, leverages with debt and manages the associated risks (annual report p24).
IBM derives 43% of its revenue from the US, 33% from Europe, Middle East and Africa, and 24% from Asia-Pacific (annual report p32).
Why is IBM a Great Business?
IBM is a great business because it has the ability to quickly change to meet client needs. The business model used to be product-based, however management wisely evolved it into a largely services-based company. In the early 1900's IBM "manufactured and sold machinery ranging from commercial scales and industrial time recorders to meat and cheese slicers." In the 1960's and 70's, the business was largely about mainframe computers. Today, the majority of IBM's revenue comes from services, not products. It is the transformation to a services company and away from a manufacturing and products company that positions IBM so well for the future.
With today's speed of change and innovation in business and technology, IBM cannot reasonably expect to maintain an advantage over the competition in building and delivering new products, but they can differentiate themselves in the services they provide. A new competitor will always come along and build a better mouse trap (no organization will ever monopolize innovation). However, IBM has strong brand recognition, an incredible network of existing clients upon which to build new business relationships, and an amazing workforce (over 425,000 employees) with experience and talent that is not easily reproduced. And the best part about this "Big Blue" machine is the workforce and company can quickly adapt to meet the needs of a changing world. This was not the case in the past because IBM was largely a manufacturing company that required a long runway of R&D. IBM is now a services company that can change quickly to meet client needs. For example, one of IBM's growth areas, cloud computing, is not only being developed by IBM, but IBM employees are delivering cloud computing consulting services for cloud capabilities developed by other organizations. Because of IBM's dynamic service oriented business model, it has the ability to maintain impressive margins, and it is very well positioned to profit no matter how businesses and technologies change in the future.
What Is The Value of IBM?
The value of IBM can be determined in a variety of ways. Some important valuation measurements are described as follows:
1) Cash Flow Analysis: IBM spits off huge cash flow. In 2011, free cash flow was $16.6 billion, and from 2000 - 2011, IBM's free cash flow grew on average by 8.5% per year (1.085^11)=(16.6/6.7).
The company defines free cash flow as net cash from operating activities less the change in Global Financing receivables and net capital expenditures, including the investment in software (annual report p56). This is a non-GAAP measure, but it gets to the point that IBM spits off a lot of cash for its investors. This is a critically important measure because it shows the company is creating value.
2) Discounted Cash Flow (DCF): A zero-growth DCF model suggests IBM is worth around $288.04:
(FCF / WACC) / shares outstanding = (16.6 / 0.051) / 1.13 = $288.04
- FCF = $16.6 billion
- WACC = Weighted Average Cost of Capital = 5.1% = Weight of Debt x Average Cost of Debt + Weight of Equity x Required Return on Equity.
- Weight of Debt = 82.6% (annual report p72)
- Average Cost of Debt = 4.95% (annual report p107)
- Required Return on Equity = Risk Free Rate + Beta x (Expected Return on Market - Risk Free Rate)
- Risk Free Rate = 10-year Treasury Rate = 1.87% (see Bloomberg)
- Beta = 0.66 (see Google Finance)
- Expected Return on Market = long-term assumption = 8%
- Shares Outstanding = 1.13 billion (see Google Finance)
The zero growth DCF assigns a value higher than IBM's current price. This is a very conservative estimate because it assumes free cash flow will not grow. If we accommodate for growth in FCF, then the value increases.
3) Benjamin Graham Model: Warren Buffett's mentor, Benjamin Graham, published a valuation model in the 1940's that I like to use:
Stock price = (Earnings/Share) x (8.5 + (2 x growth)) = $388.36
(I pulled EPS, 13.89, from Google Finance and I used the average 5-year annualized growth rate estimate by 22 Wall Street analysts, 9.73%, according to Yahoo! Finance). And interestingly, even if IBM doesn't achieve the estimated growth rate, it is still undervalued based on its current price.
All of these valuation measurements suggest IBM is a great investment opportunity.
Does IBM Artificially Inflate Earning Per Share?
Yes. The two main techniques used by management to artificially inflate earnings per share (EPS) are well-timed stock repurchases and inorganic earnings growth through high-risk acquisitions. These two techniques are common for large, cash-rich, companies struggling to grow and determined to meet internal EPS targets. The consensus, Wall Street, five-year, EPS growth target for IBM is 9.73% per annum (Yahoo! Finance IBM Analyst Estimates). For a company as large as IBM (over $200 billion in market cap), 9.73% growth is no easy task. Additionally, IBM has an internal goal of $20 operating EPS in 2015 (IBM Annual Report, p11), which is a 10.5% annual increase over the company's 2011 number of $13.44. It's no secret that IBM will use massive share repurchases and high-risk acquisitions to artificially inflate EPS (they discuss it throughout their annual report, for example p11). However, management spins these techniques as positives when in reality they are not.
Share buybacks are a common way for companies to artificially increase earnings per share (if there are less shares outstanding, then earnings per share increases). IBM has done this in dramatic fashion in recent years. IBM has spent $111 billion to buy back shares of its own stock since 2000 (annual report, p11) which is not insignificant considering the total market capitalization is currently only around $220 billion. The company has internal EPS goals (discussed previously), and buying back shares helps the "big wigs" achieve those goals and earn their "fat cat" bonuses. The share buybacks are not concerning in the short term because they create value for shareholders (if you own stock, the price of your stock generally increases when EPS increases), and because I know IBM is a profitable business because free cash flow is strong. However, share repurchases cannot continue forever (eventually there will be no shares left to repurchase). And share repurchases are a signal that management doesn't have organic growth prospects because if they did they'd spend the cash on growing the business instead of returning it to shareholders through buybacks. In the near time, IBM doesn't have the growth prospects to meet Wall Street expectations or internal EPS goals, therefore they're using share repurchases to artificially inflate EPS.
Another way IBM artificially inflates EPS is through risky acquisitions. Specifically, IBM spends a lot of money buying software companies. In the overwhelming majority of capital market acquisitions, the acquiring company overpays, and the company being acquired receives more than their company is really worth. In fact, there are many studies showing most acquisitions actually destroy value for shareholders. For example:
- The Sources of Value Destruction in Acquisitions by Entrenched Managers (Journal of Financial Economics (JFE), Vol. 106, No. 2, 2012)
- Stock Repurchases as an Earnings Management Device (Hribar, Paul, Jenkins, Nicole Thorne and Johnson, W. Bruce, March 2004)
- Why large M&A deals destroy value (Financial News, Matt Turner, Jan 2012)
The management of huge cash-rich companies (such as IBM) frequently go on acquiring sprees because they can't grow fast enough organically to meet internal goals, so they start spending cash to buy other companies which makes earnings grow, albeit at a less than optimal rate of efficiency. IBM spent $1.8 billion on five acquisitions in 2011, $6.5 billion on 17 acquisitions in 2010, and $1.5 billion on six acquisitions in 2009. If questioned, management will explain these were "strategic" acquisitions that provide unique "synergies" enabling IBM to efficaciously increase profitability. I don't believe it. These acquisitions are the desperate work of a cash-rich management team that cannot generate enough internal growth, so they grow the business inorganically, and empirical evidence (for example, see previously cited research) shows acquisitions are a sign of weakness. IBM will point to the high profit margins of the software companies they acquire, and management will also proclaim these acquisitions allow them to grow tangentially-related services business. I know better. While I believe IBM will continue to be profitable for a very long time, I believe the acquisitions and the product (hardware and software) business in general are real weaknesses of the company.
What are the Risks to IBM's Business?
Too Big to Grow: One of the biggest risks to IBM is the company becomes too big and can no longer generate enough growth to keep pace with the rest of the market. This is a very real concern for IBM because, based on market capitalization, IBM is already one of the biggest companies in the world, and achieving a high rate of growth when you are as big as IBM is very challenging.
Eroding Profit Margins: Another risk to IBM is an erosion of profit margins. Even if IBM doesn't grow as fast as the market they're still profitable. However, competition could eat into IBM's high profit margins making the stock price drop.
Obsolete Software And Hardware: IBM wisely transformed itself over time from an almost entirely product (hardware and software) based company to a largely services-based company (the majority of revenues comes from services, annual report p26). IBM has reaped huge benefits from this great foresight. As a business and technology services company, IBM can profit by offering services to a constantly changing business world. However, IBM still generates a significant portion of its profits from hardware and software, and I believe these are business that will decline as a percent of overall revenue and profit over time because the rate of change in business today is extremely high, and product-based companies struggle to keep up.
The above chart (taken from page 10 of IBM's annual report) shows IBM's hardware business has barely increased over the last decade, and I don't expect it to in the future. The software business has grown significantly (it currently has amazing profit margins - that will eventually erode), however it has been via inorganic growth which I generally don't approve of as discussed previously.
IBM is a fantastic company that makes a lot of money, and it is trading at a very attractive price relative to its intrinsic value. I believe IBM will outperform the stock market over the next ten years due mainly to its impressive services-based business model. However, I do NOT own shares, and I am NOT planning to buy shares anytime soon. There are nuances to IBM's business model that make it less than ideal. For example, I recognize management artificially inflates EPS with share buybacks, and this cannot continue forever. Additionally, I do not approve of IBM's inorganic growth through acquisitions in its software segment as discussed earlier, and the company's already gigantic market capitalization makes valuation increases through growth more challenging. I believe there are IBM competitors that present more attractive investment opportunities because they have access to similar profits through business and technology services, but they have wisely stayed out of the software and hardware businesses, and they have smaller market capitalizations which make valuation increases through organic growth more attainable. In fact, I own one such competitor because I believe it presents an even better investment opportunity than IBM. (Please consider subscribing to Daniels Report for a complete list and detailed analysis of every stock I own.)