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Your average Joe probably is not quite sure what exactly IBM (IBM) makes or does. Such ignorance could lead an investor into a trap of miscalculating IBM's importance in tomorrow's technology. What IBM does is actually quite simple to understand - it creates value. That's the secret sauce, and why IBM is a standout buy.

From an operational perspective, IBM has been adding economic value by design. IBM has chosen a path of innovation and reinvention rather than low cost commoditization. In doing so, IBM seeks to provide its customers with a differentiated offering or the next best thing (and support for it), rather than the cheapest. In doing so, it provides its shareholders with economic value-added returns.

Value addition is a condition that afflicts IBM in all of its organs. In everything the company does, it seeks to create value. When it acquires a company, it looks for synergies in its existing operations through which it can grow that business beyond what it could have done on its own. That is value creation, and it generates shareholder profit, because when that company is acquired, it is priced based on what it can accomplish on its own. IBM then grows that opportunity exponentially and finds profit and return on investment beyond compare. Just as it acquires, it is also quick to divest businesses where value cannot be added. IBM has shed a stream of $15 billion of annual revenue over the last decade, because value-added opportunity no longer existed in those businesses. This kind of asset management is hard to come by - it's dynamic, active and shareholder-focused.

IBM innovates, filing for more patents than any other company every year for the last 20 years. IBM understands the value of intellectual property in technology, and makes best use of it. The company has spent $19 billion in R&D since the start of 2010. It keeps on top of new growth markets and new growth geographies, and is thereby not left behind. Geographic growth markets contributed 24% of 2012 revenues, versus 11% in 2000, following a steadily rising trend line in between. Within its current client list, it is continually seeking to add more value per client. And the company also creates value internally through productivity savings efforts targeted to save the company $8 billion through 2015.

Value creation is the company's mantra. Within its Annual Report for 2012, IBM states, "IBM is an innovation company. We pursue continuous transformation both in what we do and how we do it - always remixing to higher value in our offerings and skills, in our operations and management practices, and in the transformational capabilities we deliver to our clients." I'll review the company's 2015 Roadmap in my next piece, as I'm picking up regular coverage of IBM.

The Results of a Value-Added Mindset

Income Statement

2012

2011

Revenue Growth

-2.3%

+7.1%

Gross Margin (Operating non-GAAP)

48.7%

47.2%

Net Margin (Continuing)

15.9%

14.8%

EPS Growth (Diluted Operating)

13.5%

From the operational perspective, you can see that IBM is adding value. Despite lower revenues in 2012, the company still made more from less. It produced value-added revenue that with more profitable margins, allowed it to still grow income at a high rate. This is the creation of value, squeezing more income out of every dollar of revenue. A steadily expanding operating margin has driven an increasing flow of free cash. Return on equity has likewise been steadily improving, but it is astronomical because of the company's significant debt load. Debt-to-equity is 175%, but IBM's EBITDA-to-interest expense ratio offers more than adequate coverage, so the debt leverage is also value added.

Chart forInternational Business Machines Corporation (<a href=

Chart at Yahoo Finance

In terms of valuation, IBM has not been left behind this year's rally, so it will not offer a standout bargain. Even so, we must keep in mind that the company's earnings estimates are on the rise, trending higher, and it has beaten estimates for at least the last four quarters. Thus, its P/E of 12.6X the analysts' consensus estimate for 2013 is probably overstated. Yet, it compares favorably to the 15.4% EPS growth achieved over the last five years. Analysts see 10.6% growth over the next five, but that figure is likely understated. The PEG ratio for this company based on the numbers is 1.19X, but is likely closer to 1.0 in truth. While the stock could give back some ground with the market near-term on the latest manufacturing data weakness, its beta coefficient of 0.65 indicates IBM's general outperformance and value creation over the years. Thus, I favor the stock for long-term interests.

Source: Why IBM Is A Standout Buy