IBM (IBM) is a remarkable value creator and enjoys a sustainable competitive advantage in enterprise software, services, and hardware. However, IBM is not alone in the information technology sector. Its close competitors, Oracle (ORCL), Cisco Systems (CSCO), EMC (EMC) and Accenture (ACN) are also value creators. The following analysis will show you that the future continues to be bright for IBM. This is an updated version of our March 17, 2013 article.
International Business Machines Corp.
IBM is an information technology company. It operates in five segments: Global Technology Services, Global Business Services, Software, Systems and Technology and Global Financing. GTS provides IT infrastructure services and business process services. GBS provides professional services and application management services. Software consists of middleware and operating systems software. Systems and Technology provides clients with business solutions requiring advanced computing power and storage capabilities. Global Financing invests in financing assets, leverages with debt and manages the associated risks. Sales March 2013, TTM: 103.2 billions$
Accenture is engaged in providing management consulting, technology and outsourcing services. The Company's business is structured around five operating groups, which together consists of 19 industry groups serving clients in industries globally. The Company's segment includes Communications, Media & Technology, Financial Services, Health & Public Service, Products and Resources. Sales, Feb. 2013, TTM: 30.09 billions$.
Oracle is a provider of enterprise software and computer hardware products and services. The Company's software, hardware systems, and services businesses develops, manufactures, markets, hosts and supports database and middleware software, applications software, and hardware systems, with the latter consisting primarily of computer server and storage products. It is organized into three businesses: software, hardware systems and services. Its software business consists of two segments: new software licenses and software license updates and product support. Its hardware systems business consists of two segments: hardware systems products and hardware systems support. The Company's services business consists of the remainder of its segments and offers consulting services, managed cloud services, and education services. Sales,Feb. 2013, TTM: 37.2 billions$.
EMC Corporation and its subsidiaries develops, delivers and supports the information technology [IT] industry's range of information infrastructure and virtual infrastructure technologies, solutions and services. EMC manages its business in two categories: EMC Information Infrastructure and VMware Virtual Infrastructure. EMC's Information Infrastructure business provides a foundation for organizations to store, manage, protect, analyze and secure information, within traditional data centers, virtual data centers and cloud-based IT infrastructures. Its EMC Information Infrastructure business consists of three segments: Information Storage, Information Intelligence and RSA Information Security. EMC's VMware Virtual Infrastructure business is engaged in virtualization and virtualization-based cloud infrastructure solutions utilized by businesses. Sales, March 2013, TTM: 22.0 billions$.
Cisco Systems Inc.
Cisco Systems designs, manufactures, and sells Internet protocol [IP]-based networking and other products related to the communications and information technology industry and provides services associated with these products and their use. It provides a line of products for transporting data, voice, and video within buildings, across campuses, and around the world. Its products are designed to transform how people connect, communicate, and collaborate. It has five segments: United States and Canada, European Markets, Emerging Markets, Asia Pacific, and Japan. The Emerging Markets consists of Eastern Europe, Latin America and Russia and the Commonwealth of Independent States. Sales, Jan. 2013, TTM: 47.3 billions$.
Creating value takes more than acceptance of value maximization as the organizational objective. All companies affirm to do this but that is not true. The choice of value maximization as the corporate objective must be complemented by a corporate vision, strategy and tactics that unite participants in the organization in its struggle for dominance in its competitive arena. That is the case of our five competitors.
How does an investor determine if a company is creating value or not? The creation or destruction of value is measured by calculating the change in market value added over the past periods. Market value added will increase if value expands by more than the amount of new capital committed to the business, and vice versa.
This behavior should give you assurance that the alpha you expect to obtain in investing in a particular stock will persist.
Market Value Added (as of March 9, 2013) (in Millions$)
|Market Value of Total Capital||214,890.61||57,087.02||181,823.60||54,242.64||134298.33|
|Market Value Added||183,391.35||45,506.81||101,820.62||18,040.90||44,536.08|
Companies that are leaders in value creation, like the five fierce competitors above, bring a different mindset and take a different approach to strategy development. They strive not just to be different from their competitors (which is necessary yet insufficient), but also to be both different from and more profitable than their competitors, like IBM does. They realize that others will seek to copy their success; therefore, they strive to develop capabilities and strategic assets that are hard to match. Creating such distinctive strategies is a difficult challenge, and only a few companies in any given industry, like the ones above, are likely to be successful at implementing and sustaining them. From where does the added market value come from and how do you know that the company will continue to add market value in the future? Simply by looking at the performance spreads over time.
Sustainable Competitive Advantage
One of the keys to finding superior long-term investments is to buy companies that will be able to stay one step ahead of their competitors. Companies that have generated returns on their capital higher than their cost of capital for many years of operation usually have a competitive advantage, especially if their returns on capital have also increased over time. This line of reasoning is fundamental. In other words, having an unexpected or a temporary competitive advantage is not enough for a business to be able to declare that it has a competitive advantage. Simply put, you cannot expect to obtain abnormal return (alpha) as an investor if the business you invest in does not have a sustainable competitive advantage. We define sustainable competitive advantage as the difference (the performance spread) between the return on capital and the cost of capital (correctly measured, that is after transforming GAAP numbers into a rigorous computation of economic profit, after deducting the full cost of capital, and eliminating the accounting distortions). The higher the performance spread, the bigger the competitive advantage. In the table that follows, we present the performance spreads over time of our five competitors.
Performance Spread [PS] (Trailing 36 months) %
It is impressive to see that they all have positive performance spreads [PS]. For Accenture, having, although slightly decreasing then increasing, a PS greater than 20 percentage points is remarkable. Oracle has also a noteworthy PS, but it has lost more than 5 percentage points in the last five years. EMC and Cisco have also noticeable competitive advantages, but they are far from the size of IBM, Accenture or Oracle. But the most prominent and stupendous fact in the above table is that with its substantial size, IBM is able to increase year over year its performance spread. It has gained 4 percentage points. Why is the IBM case outstanding?
As a long term value investor, you know that, over time, market value and intrinsic value converge. A company with a positive performance spread [PS], that is, a return on its capital greater than its cost of capital, a necessary condition for market value creation, will see it decreases to zero, if it is not able to embark on a new strategic value increasing trajectory. That is not the case for IBM. It means that IBM has a rock-solid position in enterprise software, services, and hardware. The grouping of these services and products provides IBM with an unsurpassed solution creation and delivery ability that is the key to its positive and increasing performance spread.
Equipped with the above information on performance spreads and the fact that we are in the presence of competitors that are also value creators, it follows that a breakthrough in value creation is not expected. In this competitive landscape, we have estimated the intrinsic value of those five stocks using the information above. They are presented in the following table. The comparison of the intrinsic value with the recent market price shows that IBM, Accenture, Oracle and EMC are exchanged at a price that is lower than their intrinsic value. The opposite situation prevails for Cisco. A superficial knowledge of how prices are established in the capital markets and an over confidence on a point estimate of the intrinsic values would cause some analysts to declare that IBM, Accenture, Oracle, and EMC are undervalued and Cisco is overvalued. We are not going that far, and take these results as simply supporting our overall analysis. What confidence do we have in our estimations presented so far?
Intrinsic or Fundamental Risk
To answer the question, we need to recall that the value of any company (i.e., the market value of total capital) is composed of two parts: the value of assets in place, [Va] or, the value of the current operations (i.e. the discounted value of the current net operating profits), plus the value of the future growth opportunities [Vg]. In the simplify approach that we use here, this second part is just the result of subtracting the first part, (i.e. the value of assets in place) from the market value of total capital [VT]. As you can see in the table below, [Va] plus [Vg] is equal to [VT] or 100%. The explanation is simple: The greater the market value of the total capital of the corporation is composed of the value of the current operations [Va], the less significant is the value of the most uncertain part of the total value, i.e. the future growth opportunities [Vg]. For IBM, and EMC, most of the market value comes from current operations, the most confident part of its value. For Accenture, Oracle, and Cisco you need to put more reliance on the future, and the most unpredictable part of your estimation, to arrive at the current market value of total capital.
Intrinsic Value, Value of Assets in Place, Value of Growth Opportunities
|Intrinsic Value||Recent Price||Total[VT]||[Va]||[Vg]|
Actionable advices: First and foremost, invest or stay invested in IBM. This stock is a rock-solid choice for the very risk averse investor.
Second, why not take the opportunity to diversify the IT part of your portfolio in investing in the above value creators, with the exception of Cisco? The IT part of your global portfolio will let you sleep at night.