In a recent article dated December 4, 2013, fellow Seeking Alpha author Rizzi Capital argues that International Business Machines Corporation (NYSE:IBM) has lost its way, and that the company shows signs of decay. Rizzi Capital's argument hinges on revenue declines, analyst opinions, and the premise that share repurchases are bolstering EPS. I disagree. When I look at IBM's fundamentals, I find strong arguments to own, and I have followed up my research with purchases in my IRA and my children's education funds.
Discount Free Cash Flow
After basic valuation screening, my investment analysis always begins with Discount Cash Flow Analysis (DCF). I understand that DCF has its issues, and that many investors are uncomfortable with the numerous variables that have to be estimated in DCF evaluations. I resolve some of the ambiguity through two methods.
- Deliberate pessimism - I try to use conservative measurements when estimating discount rates, growth rates, and I always include a valuation moat.
- Peer Review - I can't publish work on every stock I analyze, but I prefer to post my research on the internet to subject it to your critical eyes.
As I've stated before in previous articles, I could build a pro forma worksheet to develop five years of estimated Free Cash Flows. If I were investing other people's money, or large amounts, I would do so. As I'm risking no more than a few thousand dollars, I will use analyst growth estimates (for earnings) as a proxy. But before I do so, I want to get an idea of how accurate past growth estimates have been.
First, I'll look at past analyst estimates for earnings, and see if they consistently under or over estimate. The streetinsider.com includes 13 quarters of earnings history here.
It seems like analysts typically underestimate earnings when it comes to IBM.
Past 5 Years (per annum)
Next 5 Years (per annum)
Price/Earnings (avg. for comparison categories)
PEG Ratio (avg. for comparison categories)
Based on the analysts' history of pessimism, I feel somewhat confident in using future growth rate estimates provided by yahoo finance. Still, earnings and free cash flow are not equitable. We need to keep that in mind when using these growth rates as a proxy for free cash flow growth, especially given IBM's repurchase plans.
Income Statement ($ millions)
Cost Of Goods Sold
Selling, general & administrative
Balance sheet ($ millions)
Total operating current assets
Total operating assets
Accrued expenses (and leases/notes payable/misc)
Total operating current liabilities
Free Cash Flow Calculations ($ millions)
Tax on Operating Income
Net Operating WC
Net Operating Long Term Assets
Total Net Operating Assets
Investment in net operating assets
Free Cash Flow
free cash flow
growth rate in free cash flow
WACC/ or required rate of return
Value of operations
Value of investments
Enterprise value of firm
Value of Long Term Debt
value of all preferred stock
Value of equity
Number of shares (millions)
Estimated Share Price
Buy Under price!
I calculate Discount Free Cash Flow twice. Here, I've used 8% as a growth rate for five years, and then a horizon growth rate of 3% into perpetuity. I chose 11% as a discount rate. It's not based on the CAPM model; instead I've used my own personal required rate of return. With a 25% moat to help mitigate unanticipated risks, I come up with a buy under price of $205.61.
However, after calculating Free cash flow for the first three quarters of 2013 (the next earnings report comes out 20 Jan), I can see that it is almost certain the company will not experience a 10.7% increase in free cash. Free cash is growth is more likely to flatten then grow for 2013. Given this fact, I've decided to run a Monte Carlo simulation with 0% as my 2013 growth rate, 6% as my 2014 growth rate, 9% for 2015-2017, and 3% into perpetuity. The Monte Carlo simulation recalculates the DCF model 32,000 times, altering each year's growth rates. The simulation uses randomized rates within 1 standard deviation for the first two years, and 2 standard deviations within the last three years, assuming a normal distribution. Plotting all 32,000 results gives us the following chart.
It's hard to tell on this page what the exact range is, but the very lowest fair value estimate was calculated as $237.52 and the very highest was $301.49. Using our 25% safety moat, this gives us a fair value range of $178.14 - $226.12. That is a HUGE range, but I'm very comforted given that the stock price is currently at the very bottom of that range.
DCF analysis gives one view of a company's profitability. I'd also like to see if the company is benefiting from its investments in intangible expenses such as research and development and advertising. We can do this by depreciating intangible expenses, in this case over 7 years, and developing what's called an Enterprise Earnings statement. While this is most helpful for companies whose business relies significantly on intangible investments, such as Pfizer (NYSE:PFE), IBM spends a significant amount of money in both R&D and advertising. For those curious about my calculations, I would be glad to send you a copy of my spreadsheet, and I encourage you to pick up a copy of Hewitt Heiserman Jr.'s "It's Earnings that Count".
Intangibles Net Income
Cost of Sales
Selling, marketing and admin
Enterprising Interest expense
imputed interest operating leases
enterprise P/E ratio
A healthy company should see an increase in their per share "enterprise earnings", and we see a fairly steady trend upwards from 2007. Actually, I calculated the trend from 2003 (and the trend stands), but only included the last 6 years of data for brevity. The only disappointing information I glean from this worksheet is an "enterprise P/E ratio" is not cheaper than past years, so the current price does not seem to indicate any particular "bargain" on IBM's intangibles.
Ratios give us a simple way to compare financials between one company and its competitors to get a sense of financial health and competitiveness. Ideally, one company would be compared with another in an almost identical market. However, IBM is competing with companies producing hardware, software, cloud services, and consulting services. I chose the following four competitors because they represent "top hitters" in some of IBM's business sectors: Hewlett-Packard Company (NYSE:HPQ), Cray Inc (NASDAQ:CRAY), Microsoft Corporation (NASDAQ:MSFT), and Amazon.com Inc (NASDAQ:AMZN). I could have chosen from many more. However, many companies you could label as competitors are also IBM's customers and/or project partners. For instance, while Microsoft and IBM competed on the software front, they collaborated in hardware, with IBM supplying processors for the Xbox 360.
Return on Investment TTM
Return on Equity TTM
Return on Assets TTM
Net profit margin TTM
Sales - 5 year growth rate
Earnings per share - 5 year growth rate
P/E ratio TTM
Price to tangible Book
Price to Free Cash Flow
A few things jump to mind when I look at this graph. First, IBM's Return on Equity (ROE) is far and away the best amongst these competitors. Still, before we get too excited, it's important to note, that IBM's debt/equity ratio is also far higher than its competitors. Since debt provides leverage to a company and boosts its return on equity, we need a way to compare ROE across the graph. In this case, we could multiply each competitor's ROE by the percentage of IBM's debt/equity ratio vs that company's debt/equity ratio. For instance, IBM has 2.19 X the debt/equity level of HPQ. If we multiply HPQ's ROE by 2.19, we get an equivalent number of 45.11. If we do so, we will see that IBM still earns substantially more per unit of debt for each of these companies other than Microsoft (77.9 vs CRAY's nil, HPQ's 45.11, MSFT's 273.82, and AMZN's 8.65).
In addition, IBM leads in earnings per share growth. Rizzi Capital argued that EPS growth has been propped up by share repurchases. However, a quick calculation seems to put this argument to rest. According to Gurufocus.com, IBM had 1450.60 million shares outstanding in December 2007. On December 2012, IBM had a net income of 16,131 million dollars. If IBM's outstanding shares were the same as 2007, they would still have earned $11.12 a share. Even if we assume that every dollar IBM has spent on share repurchases over the next five years would have produced no additional income, they would have achieved an average EPS growth rate of 11.89%, still better than their peers.
Furthermore, Rizzi Capital argues that borrowing money to repurchase shares is destructive. The conservative investor in me screams agreement. However, IBM's current borrowing costs seem to be extremely low. By dividing interest expense ($459 mil) by long term debt ($24088 mil), we can get a rough idea of their borrowing costs. With borrowing costs just below 2%, and a near 1.5% after tax rate, borrowing to repurchase stock right now is anything but destructive to shareholder value. With cost of capital estimated at 5% by Duff & Phelps, IBM can theoretically net a risk free return by borrowing money to repurchase shares.
I'd also like to point out that IBM comes in as a close second in regards to Return on Investment, Return on Assets, and the current P/E ratio. IBM is a distant second in the category of Net profit margin. It bears mentioning that Microsoft is leading in those areas, and may merit a look as an investment potential.
IBM's big weakness seems to be in the areas of sales growth, inventory turnover, and debt levels. However, as long as the company can grow its sales, sluggish inventory movement is not a death sentence since IBM squeezes more profit out of each sale than most of its competitors. High debt levels serve as a red flag for me, but as long as IBM can maintain extremely low debt costs, and can continue to grow its net income, debt should not prove a hindrance to the company.
There are no riskless investments, and IBM shares face some significant hurdles that we should address. First, while revenue declines do not in and of themselves demonstrate stagnation in the business model, they do hint at two related problems. As IBM transitions out of hardware sales and into the realm of software and servers, they face increasing competition from rivals established in those realms, such as Amazon, Oracle (NYSE:ORCL), and Microsoft. Stealing market share from these giants on their own turf will be difficult. We could write off some revenue decline in the past due to the changing business model, but as margins get more efficient, it will be harder for IBM to improve them. At some point growth MUST come from increased software sales.
Furthermore, IBM has an aggressive share buyback plan in place, an aggressive R&D budget, and a significant dividend. But, to keep up with its rivals, IBM is likely going to have to step up expenditures in R&D and acquisitions, at a time when purchasing cutting edge software companies is anything but cheap. IBM could cut back on its share buyback plan, or increase its debt load. Either of those could put a damper on share price, especially as cost of debt is more likely to rise in the near future than fall.
Finally, one must consider stock price momentum. The one year return on shares of IBM shows a loss of around 3% while the overall market returned nearly 30%. However, the one month return on IBM is 7% vs the markets 4% return. With the recent run up, it is certainly possible that momentum is shifting for the positive.
Rizzi Capital argues that declining revenue is a sign that IBM is in decline. Rizzi compares revenues from 1996 to now, and argues that revenue has not kept up with inflation. Without a "clear strategy for reinvigorating growth, IBM will be in a lot of trouble". But IBM does have a clear strategy. It is posted right here. The one sentence summary is IBM is moving from lower margin hardware sales to higher margin software and consulting services. IBM states that the share of pre-tax income from hardware has dropped from 35% to 14% in the past 12 years, while services and software shares of pre-tax income have grown by 19%. Shrinking revenues is not overly positive. As an investor, I want to see total dollars in sales increasing. But maybe this is a story about a company's successful switch from selling very expensive products with small profits, to selling, just as successfully, cheaper products which make much more profit.
IBM's growing earnings and cash flow seem to indicate so. Despite what Rizzi indicates, earnings would have grown significantly despite share buybacks. IBM isn't just taking advantage of historically low interest rates to buy back shares, now at bargain basement prices. They are buying up companies such as SoftLayer Technologies, to expand their presence in the growing cloud computing industry, and teaming up with competitors such as Cisco and Oracle to build up core competencies.
When I look at IBM, I see a broadly diversified company on sale because of Wall Street's current "revenue fever". Cash flow matters and IBM has it. IBM isn't a grand slam though. I see red flags. IBM is facing tough competitors, and is going to have to invest significantly more money to compete effectively in new arenas. IBM's debt load is very high, and likely to get higher. Cost cutting and improving margin efficiencies will only foster growth for so long. IBM is going to have to find a way to grow sales faster. Still, I feel that the market has currently discounted shares more than enough to compensate for risks the company faces. With earnings reports coming out on the 20th of January, cautious investors may want to wait until after next Monday. Thank you for taking the time to read, and please feel free to comment.