Seeking Alpha
Long/short equity, research analyst, tech, alternative energy
Profile| Send Message|
( followers)  

IBM (NYSE:IBM) is the one of the world's largest technology companies, with a big presence in the hardware, software and services segment. The company is one of the pioneers of the technology industry, along with HPQ (NYSE:HP) and is responsible for many of the crucial inventions (typewriters, mainframes, PCs) that have shaped the industry today. IBM has outperformed its major software peers like Oracle (NYSE:ORCL), SAP (NYSE:SAP) and Microsoft (NASDAQ:MSFT) in the last 5 years, giving an 88% return to investors. However, over the last year the return has become quite tepid, as concerns over its stagnating revenues and increasing competition has concerned investors. We think that IBM may not be the best investment in technology services now, given that it can't seem to grow its topline. Its dividend yield at 1.7%, is also not exciting enough for a value/dividend investment.

IBM Concerns

  1. Competition increasing in core Services - IBM is facing increasing competition in its core services segment. The hardware majors like Dell (NASDAQ:DELL) and HPQ are increasingly focusing on services, to offset their weakening hardware segments. Software and services have much higher margins than hardware and also face much lower competition from low cost Asian competitors. This is making US technology companies like Xerox (NYSE:XRX), increase their resources in services through organic and inorganic growth. Indian IT companies like Infosys (NYSE:INFY) have also become big players and are competing with IBM for the big multi-million dollar deals.
  2. Absent in the Consumer Technology Space - IBM does not have a strong presence in the consumer technology segment, after selling its PC division to Lenovo in 2004. The company is very strong in the enterprise computing space, but has completely abandoned the consumer technology area. Apple (NASDAQ:AAPL), Google (NASDAQ:GOOG) and other companies have managed to dominate and prosper enormously after IBM vacated this segment.
  3. Topline Growth is Stagnating - IBM's topline growth has stagnated over the last decade. The company seems to have hit a ceiling of ~$100 billion in revenues, which it can't seem to grow despite acquisitions. Compared to IBM, smaller services focused companies like Cognizant (NASDAQ:CTSH) have grown revenues in high double digits. The stagnating revenues are the biggest red flag for an IBM investor. It is difficult to increase earnings on a sustained basis without growing your topline. There is a limit to how much you can squeeze out earnings by cutting costs through outsourcing.
  4. Margins don't have a lot of upside left - IBM has managed to grow earnings in the last few years by increasing its margins, as revenues have more or less remained at the same level. The company has managed to increase its Gross Margin and Operating Margin by almost 1% every year in the last 10 years. This has led the ROE and ROIC to increase to very high levels of 73% and 30% respectively. EPS has almost tripled in this period from ~$4 to $14.
  5. Dividend Increasing but Buybacks not really effective - IBM has started to increase dividends being given to shareholders and gave an annual dividend of $2.9 in 2011 (almost 5x times increase from 10 years ago). However, the current dividend yield of 1.7% is not really too exciting, as there are concerns whether the company can grow its earnings in the future. The payout ratio at around ~20% is reasonable and can be easily serviced. A large part of the share buybacks has not really helped shareholders as they have been used to offset the dilutive effect of stock compensation. IBM has bought a huge amount of stock since 2000 but it has mostly helped the management till now
  6. Valuation is not Cheap - IBM trades at above industry multiples with a P/B of 10.2x and P/S of 2.2x. The forward P/E of ~11x does not seem expensive, however it is not too cheap given the absence of topline growth. The company unlike some of the other technology companies has a relatively high debt equity ratio of 1.1x. The company has returned most of the free cash flow to shareholders in the form of dividends and buybacks.
  7. Acquisitions not providing too many gains - IBM uses acquisitions of small innovative companies to keep up with newer technology trends, however we have not seen any big returns from these acquisitions. The company recently bought StoreIQ to shore up its offering in the upcoming "Big Data" segment.

IBM upside risks

  1. Management has done a lot of things right - Amongst the old technology companies, IBM has been more adept at adapting to newer trends. The hardware was increasingly becoming a Commodity and got out early by selling to Lenovo. Other technology companies like Xerox have sunk to new lows, as they could not adapt quickly enough. IBM also was amongst the first companies to move a big part of its workforce to India to gain the offshore advantage. The company successfully copied the low cost model of the Indian "offshorers" like Wipro (NYSE:WIT). IBM management has managed to successfully navigate the treacherous currents of the technology industry for a long time now. The company is moving into newer areas like Smart Grid, Big Data to offset slowing growth in existing segments.
  2. Research and Technology Focus- IBM has one of the biggest R&D budgets in the industry and spends resources on developing a wide variety of products/services such as semiconductors, cloud computing, social networking, mobile computing, "Big Data" etc. The company has one of the biggest technology patent portfolios and during the last 20 years, IBM was given nearly 67,00 patents by the US Patent Office.
  3. Low Hardware Exposure - IBM has almost halved its exposure to the hardware segments in the last decade. The company now gets less than 20% of its profits from the low margin and highly competitive hardware segment. This has proved highly beneficial, as hardware dependent companies like Dell have seen serious value erosion.

Stock Performance

IBM has outperformed the rest of its peers in the enterprise computing space giving an 88% return over the last 5 years. The stock has more than doubled over the past 10 years, giving ~146% return to the shareholders. The stock came into focus after Buffett invested in IBM because of its shareholder friendly nature.

Summary

IBM stock has had a spectacular run in the last decade, as the company managed to increase margins despite revenues remaining more or less stagnant. The company's shift to software/ services and increasing offshoring were the main contributors to the margin expansion. However, we think that these factors have been played out. Competition is increasing in the company's main bread and butter segment, from other technology giants. Newer trends of cloud computing and virtualization also are big threats to the company's high margins. IBM has solid competitive strengths in terms of its presence across technology segments and a huge patent portfolio; however we don't think that the stock has a lot of upside left at the current level.

Source: IBM - The Bear Case