Susan M. Byrne is Chairman and CIO of Westwood Management and its sister company Westwood Trust, wholly owned subsidiaries of Westwood Holdings Group (NYSE: WHG). Westwood Management and Westwood Trust manage over $10 billion in assets.
We had the opportunity to ask Susan for the thesis behind her single highest conviction holding in her portfolios at this time.
If you are a fund manager and interested in doing an interview with us on your highest conviction stock holding, please email Rebecca Barnett: firstname.lastname@example.org
• • •
Seeking Alpha (SA): What is your highest conviction stock position in your fund currently - long or short?
Susan Byrne (SB): We think that International Business Machines (IBM) is attractive for those looking for a high-quality investment. IBM is generating high levels of recurring revenues, free cash flow and earnings growth while also carrying a strong balance sheet.
As we look forward, we expect liquidity to be gradually removed from the economy through a variety of Fed actions, and the resulting lower liquidity levels will be a key factor driving performance in 2010. This reduction in liquidity will lead to lower investor risk tolerance and a rotation into these higher quality securities. In addition, we expect the consumer deleveraging process to continue and unemployment levels to remain high, resulting in subpar consumer spending.
This will likely lead to a more tepid rate of domestic economic growth in 2010 than the consensus expects, which will also create demand for high quality companies that can take market share and produce solid earnings in a sluggish economy. Multinational firms should fare better than purely domestic firms as companies solely focused on U.S. end markets will produce slower earnings growth than those with exposure to faster growing foreign markets.
IBM is representative of these high quality, large cap stocks that should be more highly valued over the coming years. While much of the near term economic recovery has already been priced in, we believe high quality large cap securities, namely securities rated “A-“or better by S&P, have much greater near term potential and are as much as 25% undervalued. Historically, such companies have traded at a 20% P/E premium to the broad market, but after the 2009 low quality rally, are now trading in line with, or at a discount to, the broad market. The combination of this valuation discount coupled with the above mentioned positive attributes of such companies produces a bullish case for high quality, large cap securities such as IBM in 2010.
SA: To what extent is this an "industry pick" as opposed to a pure bottom-up selection?
SB: As we mentioned above, IBM is a high quality company that should benefit from the market’s desire for safety. However, although IBM is a member of the Technology sector, exposed to IT spending trends in the US and abroad and a high quality large cap security, it is more a straight stock pick as opposed to an industry selection.
IT worldwide spending has begun to pick up as evidenced by US tech durable spending in December. Global IT spending, especially in PCs, has also increased and we expect tech spending to increase for the remainder of 2010. Worldwide, IDC expects tech spending to increase 3% in 2010 and IBM will benefit from this trend as well as its strong position as an industry leader, taking share with new product introductions.
However, IBM also has several company specific drivers that lead it to be a favorite bottom-up stock pick. Revenue guidance for the company appears conservative given new System Z and P product launches. Services signings have been stronger than expected and software revenues are expected to grow by double digits in the near term as large deal closing were pushed out into this quarter.
IBM, over the years, has migrated its mix away from reliance on hardware sales and toward more software and services while also expanding margins within these units via cost cuts and increased productivity and utilization efficiencies. Significant amounts of restructuring in 2010 will yield incremental savings and margin expansion. If IBM meets their margin goal of being in the top quartile among S&P companies for pre-tax margins, they should exceed 20% by 2011.
Coincident with the mix shift, cash flow generation has been strong (over $5B in 4th quarter 2009 and approximately $16 billion in 2010) allowing for annual dividend increases. In fact, IBM has raised its dividend rate annually for the last fourteen years, now carries a dividend yield of 1.8% but still only uses 18% of its cash flow to fund the payment. Lastly, IBM is attractively valued at just 11x 2010 earnings, 7x EV/EBITA and 10% FCF yield, despite its double digits EPS growth, high Free Cash Flow margin and guidance remains conservative. Competitors and other comparable companies trade at slightly higher valuations.
Having beaten consensus expectations in each of the last 9 quarters, we believe IBM is poised to continue exceeding expectations and, when coupled with strong fundamentals and an attractive valuation, IBM is an attractive bottom-up pick.
SA: How would you say IBM is currently positioned vis a vis its competitors?
SB: Relative to competitors, IBM is the industry leader. The strength of its portfolio approach (service all the needs of the client) can be seen in the recent moves of its peers. IBM for example has products that serve enterprise customers’ servers, storage, software, services and financing needs. Competitors such as Hewlett Packard (HPQ) , Dell (DELL) and Cisco (CSCO) have recently made acquisitions that position their product lineups better, relative to IBM.
SA: What is the current sentiment on the stock?
SB: Current sentiment is relatively positive, with the majority of sell-side analysts rating the stock a buy. Over the last year the markets have favored smaller market capitalization, lower quality companies that are highly levered to an economic recovery. Therefore, while there is little doubt about the overall quality of IBM, performance of the stock has lagged. So, as economic uncertainties begin to impact investor risk aversion, high quality companies such as IBM should begin to outperform. Just as important, however, is that we believe IBM’s strong fundamentals and attractive valuation mute downside risk. Valuation is currently at very attractive levels and downside targets of 8.5x earnings and 12% yields (multi-year lows), yield risk of approximately 20%.
On the upside, we believe that IBM can deliver on its promise of at least $11 in EPS in 2010 and that it can generate double-digit EPS growth over a 3-year investment horizon. At 14x, the shares could be worth over $200/ per share, yielding a reward / risk ratio of over 3x.
SA: What could go wrong with this stock pick?
SB: The largest risk to IBM is a worldwide economic slowdown that could cause revenue growth to dip in all its segments. Additionally, IBM’s ability to successfully transition into new product cycles for mainframes and Unix servers. Should IBM’s transition not proceed as expected, the result could be margin pressure or lost market share.
Despite the risks, we believe IBM’s valuation remains compelling as earnings are understated relative to peers (they state earnings on a GAAP basis while peers do not) and the company has transformed its portfolio. Moving from a company leveraged purely to hardware sales toward a mix of hardware, services and software that more effectively delivers increased margins, recurring cash flow and revenues as well as double digit EPS growth provides an investor with a solid, high quality investment.
SA: Thank you very much, Susan.
SB: Happy to participate.
Disclosure: Westwood Management and Westwood Trust hold IBM in client portfolios