Let's get to right down to the "meat on the bone"; if you take a look at IBM from a financial analysis perspective, the first item that jumps out is that IBM has an absurd return on equity, an ROE that blows away both Apple (AAPL) and Google (GOOG). IBM's ROE is over 85%, compared to Apple's mere 31%. Never fear, the ROE is real and the stock could easily see over an annualized return of 22% over the next year and a half.
Let's dig into the IBM fundamentals and look at it from a DuPont Analysis standpoint to see exactly why IBM has an ROE nearly triple that of Apple.
In breaking down the ROE components, we see that Apple actually has a higher net profit margin and the two trade in line with respect to total asset turnover. However, it's the equity multiplier where the two, Apple and IBM, greatly diverge. IBM has been on a tear over the last 10 years of growing debt and shrinking shareholders' equity (more on that later), putting its debt-to-equity ratio at upwards of 1.75 and helping IBM generate returns on equity of over 85%.
But even when accounting for IBM's debt load, the company still generates an outsized return on invested capital.
Expanding on the ROIC from above, let's stack up how the companies are performing relative to their costs of capital. IBM still appears to dominate, being able to generating returns over six times what its cost of capital is. Apple's is robust, but its weighted average cost of capital is higher (WACC) and ROIC lower than IBM.
IBM's WACC of 5.2%, compared with the most recent return on invested capital of 31.5% suggests that Big Blue utilizes its capital very effectively to generate profits.
The real lesson here is that IBM is getting no respect. Although IBM has managed to see a steady up-and-to-the-right trend over the past five years, the stock has still managed to underperform Apple by nearly 80% over the time period.
Now, let's just take a quick step back and catch on up exactly what IBM is;
IBM's global capabilities include information technology services, software, computer hardware equipment, fundamental research, and related financing.
In the equity analysis business, IBM is commonly referred to as Big Blue given the company's use of blue products, packaging and logo, not to mention the company is huge. Fortune ranked Big Blue as the second-largest U.S. firm in terms of employees, fourth largest by market cap and ninth most profitable.
Of late, IBM has been transforming itself into a services and software company. Although computer hardware accounted for about 17% of sales in 2012, Big Blue hopes to transition away from that business even further by making acquisitions in the service and software space. Its services segment accounted for over 56% of 2012 sales and software 24%.
It just so happens that IBM is making good on this strategy of late; announcing this week IBM is snatching up SoftLayer Technologies for over $2 billion. SoftLayer is a provider of cloud computing infrastructure that allows clients to buy enterprise-class cloud services on dedicated or shared servers.
This is just another step to meet IBM's 2015 goal of reaching $7 billion annually in cloud revenue by the end of 2015.
Back to the meat, let's break down IBM a bit more with a deeper look at some of its financials and the "high" debt we touched on earlier.
Here is where the story gets interesting. IBM's ROE is head-and-shoulders above the likes of other tech companies, Apple and Google, however, IBM is generating such outsized returns by taking advantage of debt markets. IBM has been levering itself to continue buying up shares, reducing its shares outstanding and shareholders' steadily over the past 10 years.
Thus, its debt to equity has grown over this time; now at nearly 1.75.
Question is; should investors be worried about IBM's debt, and has IBM been cheating when it comes to growing its ROE? We think investors have nothing to worry about when it comes to IBM's debt, nor is IBM's ROE a fad, as even accounting for debt, we saw that IBM has a ROIC that's in excess of Apple.
IBM's long-term debt has grown to $33 billion as of the last quarter, however, IBM also has nearly $12 billion in cash and short-term investments, and the company generates some $15 billion in free cash flow per year. Thus, it appears investors can rest assured that IBM will be able to service its debt over the interim.
What's more is that Moody's rates IBM's debt as prime, having a better credit rating than other major tech giants Cisco and Intel.
What's the future hold?
If there is one worry it's whether or not IBM can continue growing revenues at a robust rate. Over the past 10 years, Big Blue has grown revenue over 20%, now generating some $100 billion in revenues per year.
A few of IBM's initiatives for revenue growth include tapping growth markets, breaking into business analytics, and of course cloud computing, where these initiatives are expected to deliver at least $50 billion in revenues by fiscal 2015.
Even if revenue growth appears to slow, there's no fear for EPS growth, where IBM plans to continue expanding margins with a transition to higher-margin software and service business.
Margin expansion: By improving efficiencies, IBM generated cost savings of $6 billion over the 2007 to 2011 period, and expects to save $8 billion by 2015 based on improvement in enterprise productivity. IBM also managed to grow its gross profit margin to 48.1% in fiscal 2012, up from 46.9% in 2011. Gross margins should expand further as IBM targets revenue from software to contribute 50% of profit by 2015.
Acquisitions: IBM has also been building its portfolio through strategic acquisitions, where during fiscal 2012, IBM completed eleven acquisitions for nearly $4 billion, and plans to spend $20 billion on acquisitions through 2015.
Rewarding shareholders: IBM has been returning cash to shareholders for over a decade. From 2000 to 2011, IBM returned $133 billion to shareholders in the form of dividends and share repurchases. In fiscal 2012 alone, the company returned over $15 billion. Management expects to buy back shares worth $50 billion over the next five years and return $20.0 billion in the form of dividends to its shareholders.
Let's face it, billionaire investors love high-growth stocks, but it appears the hedge fund heat surrounding Apple might be cooling. During the first quarter, the likes of billionaires David Tepper of Appaloosa Management, Julian Robertson of Tiger Management and George Soros of Soros Fund Management sold off their entire stakes in Apple. Worth noting is that David Einhorn of Greenlight Capital continues to sing Apple's praises; he upped his shares owned of Apple by 83% during 1Q 2013.
For IBM, Warren Buffett of Berkshire Hathaway still holds one of the most valuable positions, worth close to $13 billion and making up 17% of his portfolio.
Most notably, billionaire and founder of Renaissance Technologies, Jim Simons has traded out Apple for IBM. At the end of 2Q 2012, Simons had Apple as his hedge fund's largest stock holding. He then cut his position in 3Q 2012, sending Apple to 10th and then 15th during 4Q 2012. Finally, in the first quarter of this year Simons sold off his entire stake in Apple; meanwhile, he boosted his stake in IBM by 456%, shooting Big Blue from 95th in his portfolio to 3rd.
Quickly running through the valuation, we see that IBM could offer investors upside of nearly 37.5% over the next 19 months. In looking at how analysts believe the company will grow, we see that IBM is undervalued relative to the market.
Analysts expect IBM to grow EPS at a 9.1% compounded annual growth rate over the next five years, while the S&P 500 is expected to grow at 9.7%. However, the S&P 500 trades at a large premium to IBM. IBM trades at 11.2x forward earnings, versus the S&P 500's 14.8x. What's more is that the 10-year average P/E ratio for IBM is nearly 15x.
Thus: (1) assuming that IBM should trade at 15x earnings at the end of 2014, which is only slight multiple expansion from its current 14.2x trailing P/E, (2) the stock meets 2014 consensus EPS estimate of$18.57, and (3) $5.50 in dividends are paid out (no dividend growth), then the total upside is 37.5%, or an annualized 22.2%.
IBM has been using its low-borrowing rate to tap the debt markets, then returning that money to investors via share buybacks. This, along with the company's continued ability to grow it top line and expand margins, has allowed investors to see returns on equity in excess of 80%.
We think IBM can execute its strategy of transitioning toward becoming a full-blown service and software company, which will only further expand margins and increase returns on equity.
For investors truly concerned about IBM's debt or potential growth, you can always consider buying some protection with covered calls using an income-oriented strategy.