The last time I wrote about IBM (IBM) the stock was 42% undervalued. Since that time, the valuations have increased, and the company is now 35% undervalued. In this article, I forecast fiscal third quarter revenue. Also, there are some recent developments since the last time I published. Further, peer company comparisons of second quarter financial performance is included.
All of that said, I'm forecasting third quarter revenue to grow relative to the prior year. The increase in revenue could act as a catalyst to drive the share price toward its intrinsic value. A fiscal 2014 revenue increase could be the catalyst investors need to accumulate shares of IBM.
I'm going to review Accenture's earnings report this week as an indicator of potential revenue from IBM's services businesses. Also, IBM's hardware business may have continued its slump in the third quarter. With that in mind, I maintain my view that IBM's shares are undervalued and that the market will start to price in revenue growth.
- IBM added a security division when it acquired Q1 Labs.
- IBM announced that it acquired Daeja Image Systems Ltd., a leading provider of software that makes it easier for business and IT professionals to view large documents and images. The acquisition of Daeja should enhance the solution offerings of the Software segment.
- IBM was named a leader in cloud professional services by IDC.
Second Quarter Review
I'm going to compare the second quarter financial performance of IBM, Microsoft (MSFT), HP (HPQ) and Oracle (ORCL). These companies operate in different industries and the same industries, but they operating within the same sector. For investment purposes, these companies can be substitutes. The objective is to add depth to the analysis of IBM's second quarter financial performance.
IBM's revenue in the 2013 second quarter was about $1 billion less than last year's revenue and just under $2 billion less than 2011 revenue. Lower revenue and higher SG&A expenditures contributed to contracting profitability margins, but net income was down $400 million relative to 2011 net income (revenue declined roughly $2 billion).
I consider the quarter ending in May of 2013 to be the end of Oracle's second quarter. Minding the aforementioned, Oracle's revenue increased in the second quarter of 2012 and 2013. The revenue increases acted as a tailwind to gross margin and operating margin expansion. EPS increased substantially on higher net income and lower shares outstanding.
Microsoft's second quarter is defined as the quarter ending June of 2013. Microsoft's revenue increased in 2012 and 2013. Higher revenue didn't translate into higher gross or operating margins, but Microsoft is reducing operating expenditures - on a relative basis - to offset the declining gross margin. While revenue increased about $2.5 billion between 2011 and 2013, net income declined by almost $1 billion. The shares outstanding didn't decline much during the period.
Hewlett-Packard's second quarter is defined as the quarter ending in July of 2013. Beside the shrinking top line, the gross and adjusted operating margins have been flat, which is impressive. Declining EPS is being cushioned by declining shares outstanding.
Oracle's financial performance has been the strongest followed by IBM. IBM's financial performance is being adversely impacted by a challenging 2011 comparison. Microsoft is facing margin pressure, and HP has done an excellent job managing expenses. Based on this section alone, I'm bullish on Oracle and IBM, and neutral on Microsoft and HP.
Forecasting IBM's Third Quarter
The bulk of IBM's fiscal year revenue occurs in the fourth quarter, but the third quarter will be important because I'm expecting revenue growth relative to the prior fiscal year. At worst, IBM's revenue should be flat. All of that said, I'm maintaining my revenue outlook, but could decrease my forecast during the fiscal fourth quarter.
I'm looking for third-quarter revenue of $25 billion to $26 billion, which would be an increase relative to last year's third quarter revenue of $24.7 billion. The operating margin should be about 19% and the net income margin should be around 15.4%.
I maintain my full-year revenue range of $101 billion to $103.5 billion, with EPS of at least $14.14. Management is expecting EPS of $15.08. The full-year results will be heavily impacted by what is typically a seasonally strong Q4. So, the majority of the forecasting risk is in the fourth quarter. Also, I continue to expect fiscal 2014 revenue of $104 billion to $108 billion with an operating margin of 20+% and a net income margin of 16.5+%. The fiscal 2014 EPS forecast is $16.34.
I'm looking for revenue growth in the third quarter, which would be a positive sign heading into the fiscal fourth quarter and fiscal 2014. Accenture's earnings report later this week will provide some clues to IBM's performance this quarter and could impact the stock price of IBM. Third quarter revenue may come in flat on soft hardware sales - based on Oracle's recent earnings release. Also, services sales may continue to be sluggish.
I'm going to use a few models to value the common equity shares of IBM. I'll use discounted cash flow models and multiplier models. At the end, the average of the valuation models is the intrinsic value. The current share price of IBM is $191.28; I estimate that the required rate of return for shares of IBM as 7.13%.
Assuming a 6% sustainable growth rate, I estimate that the intrinsic value of IBM shares is $327.43. If the dividend grows to $4.07 in fiscal 2014, the intrinsic value is $360.18. Thus, given the current share price, IBM is substantially undervalued using this model.
Using a payout ratio of 21%, I estimate the justified PE ratio as 18.58. Including my EPS forecast, the intrinsic value of IBM shares is $282.21. Using this model, IBM is substantially undervalued.
The multiplier model valuations will probably say that IBM is overvalued. The intrinsic value using the price/earnings ratio is $176.62, using the price/book ratio is $148.09, using the price/sales ratio is $164.04, using the price/cash flow ratio is $171.08. The average of those values is $164.96 - this model is saying IBM is overvalued.
The average of the models and the intrinsic value of shares of IBM is $258.20, so IBM is undervalued by about 35%.