Could IBM Be Fairly Valued?

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 |  About: International Business Machines Corporation (IBM)
by: Early Retiree

When International Business Machines (NYSE:IBM), the bluest of the blue chips, gets hammered by the talking heads like it happens these days, it might pay off to take a thorough look at the company. As investors we always have to remember the old story about the $20 bill:

An economist who firmly believes in the efficient markets hypothesis (EMH) is walking down the street with one of his friends.

Suddenly the friend says, "Look, there is a $20 bill on the ground!"

The economist replies, "That's impossible. If there really was a $20 bill on the ground, somebody would have already picked it up."

In other words: If there is a bargain around, you have to check and find out on your own.

Everybody knows IBM. What information can I come up with that has presumably not already been priced in the stock? Very often I have found out that information is not the same as knowledge. All information is publicly available, but few people really understand it, think through combinations and possible dynamics. Everybody sees the $20 bill (that's the information), but few pick it up and check (but only this leads to knowledge).

If we take a look at the 2012 annual report we find the following information:

"Approximately 60 percent of external Global Services segment revenue is annuity based, coming primarily from outsourcing and maintenance arrangements. The Global Services backlog provides a solid revenue base entering each year. Within Global Services, there are two reportable segments: Global Technology Services and Global Business Services."

"Approximately two-thirds of external Software segment revenue is annuity based, coming from recurring license charges and ongoing post-contract support."

(IBM 2012 Annual Report, page 23)

So let's put this information together with the figures of the last four quarters:

Q4/12

Q1-Q3/13

SEGMENT

Pre-tax profit

Pre-tax profit

GTS

2,027

4,994

GBS

841

2,274

Software

4,017

6,897

S&T

974

-713

GF

518

1,582

Total

(before consolidation)

8,377

15,034

EPS (non-GAAP)

5.39

10.21

EPS (GAAP)

5.13

9.27

Click to enlarge

So how much is the recurring part of these pre-tax profits? Let's apply the stated percentages of 60% to Global Services and of 66.7% to Software. I would also apply the 66.7% ratio to Global Finance and only 10% to Systems & Technology. (We can presume that most of the Global Finance revenues, but only little of Systems and Technology revenues are recurring.)

As a consideration aside, please note that the recent earnings slump was entirely in the Systems & Technology segment, while all other segments actually grew pre-tax income compared to Q3/2012. The IBM Road Map projects the annuity based proportion of the revenues to increase over the next few years.

Recurring income calculation (TTM)

SEGMENT

Pre-tax profit

of which recurring %

recurring $

GTS

7,021

60.0%

4,213

GBS

3,115

60.0%

1,869

Software

10,914

66.7%

7,280

S&T

261

10.0%

26

GF

2,100

66.7%

1,401

Total before consolidation

23,411

63.2%

14,788

Click to enlarge

Almost 2/3 of profits are annuity based! This translates into $10.70 of the expected 2013 non-GAAP Operating EPS of $16.90.

Now let's virtually split IBM into two distinct companies: one that only gets the recurring revenues and one that heavily depends on the economic environment with almost no recurring revenue streams. What would they be worth?

A business with a powerful brand, good pricing power, sticky client relationships and 100% recurring revenues provides excellent inflation protection. A PER of 20 can easily be justified. On the other hand, the remaining part of the business should maybe trade at an average PER of only 10.

If we apply these multiples to IBM's GAAP and non-GAAP Operating EPS (each split into the recurring and the non recurring part), we get the following:

Fair value calculation

$

non recurring

recurring

EPS (non-GAAP)

15.60

5.75

9.85

EPS (GAAP)

14.42

5.31

9.11

Fair PER

16.32

10.00

20.00

Fair value (non-GAAP)

254.54

57.46

197.08

Fair value (GAAP)

235.29

53.11

182.17

Click to enlarge

Thus, IBM should trade at a fair value of 16.32 times earnings (which is where it actually traded at its peak in 2007).

At the current price of about $175, IBM trades at 12.13 times its TTM GAAP EPS or only 11.21 times its non-GAAP TTM Operating EPS. This means that you are paying about 8 times the non recurring earnings plus 14 times the annuity like earnings. In my opinion this is far too little, especially in the current low interest environment.

Furthermore, if you believe management's Operating EPS guidance of $16.90 for 2013, the stock trades at only 10.36 times this year's earnings. This translates into 8 times the non recurring earnings plus 12 times the recurring earnings. Only if you believe that a stable annuity based business which owns one of the most respected brands on the planet is worth only 12 times earnings, you may consider IBM fairly valued at $175 per share. In my opinion it is worth far more than that.

Disclosure: I am long IBM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.