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While searching for dividend growth companies for an experimental portfolio (you can see the dividend growth portfolio here), I came across IBM, and as I did further research into its recent troubles one thing became very clear to me. Over the last century, this company has proven itself adaptable and a true friend to Dividend Growth Investors. Thanks to the short-term weakness in 2013 revenues, this buyback and dividend growth king is trading at an exceptional discount to fair value.

IBM is one of America's oldest companies, having been founded in 1910. Yet, throughout 103 years of technological change IBM has managed to not only muddle along and outlast its competitors, but it has thrived and proven itself both adaptable, highly profitable and very shareholder friendly.

IBM Revenue (<a href=

As seen in this graph, IBM has, in the long run, grown revenues dependably and strongly. However, in the short term it often appears as if sales are falling off a cliff or stagnating or gradually in decline. This is because of the nature of the technology and IT industry. It's a cyclical world where company investment in IT cap-ex comes in waves. Where innovations and new threats from competitors require IBM to retrench, catch its breath, create a plan to come back stronger than ever and then execute that plan.

IBM EPS Diluted Chart

IBM Chart

Since 1962, IBM has returned 8.81% CAGR. When dividend reinvestment is included this figure jumps to 10.8% CAGR. That is 20% better than the market's 1871-2013 CAGR of 9%, over a period of half a century.

An important thing to notice about this long-term price chart for IBM. There are long periods of massive growth, followed by large declines. Gains of 400, 500 even 1000% followed by a sharp sell off, inevitably followed by new, record highs, a few years later.

In 2011, it became known that Warren Buffett's Berkshire Hathaway had purchased $11 billion in IBM and that the company represented Berkshire's 3rd largest stock holding after Coca-Cola (KO) and Wells Fargo (WFC). Some people such as Martin Sosnoff, CEO of Atalanta Sosnoff Capital, scoffed at the purchase, calling Mr. Buffett a "lost tycoon" and stating, "I'm bothered by Buffett's final morphing into his staid money management construct, saddling himself with underperforming big capitalization properties like Exxon Mobil, IBM and Wal-Mart." Critics such as Mr. Sosnoff seem to think that large, boring, dependable dividend growers such as Exxon Mobil (XOM), Wal-Mart (WMT) and IBM, are doomed to permanent market underperformance. I will now show why they are wrong.

IBM Dividend Chart

Now, it is true that Warren Buffett is a big fan of boring dividend growth companies, which is why his 4 largest holdings are Coca-Cola, Wells Fargo, IBM and American Express (AXP). All of these companies are dividend growth champions who have decade-long histories of rewarding long-term shareholders with fast growing dividends. In fact IBM has grown its dividend 17 consecutive years at an annual compound growth rate (CAGR) of 14.08%, 13.7% over the last 5 years. Yet after such growth the company's payout ratio is just 25% meaning there is a long runway for many more years and decades of strong dividend growth to continue.

But for dividends to grow, so must earnings. So let's address the heart of Big Blue's recent woes. IBM's hardware segment, systems and technology experienced a 26% decline. Sales in China were also substantially weakened by that government going through their own reassessment of its IT demands. According to the most recent earnings call, the same was true with global IT in 2013, with IBM being caught in a trough in the cyclical nature of the hardware replacement cycle. Yet despite the challenges, IBM was able to grow EPS by 14% in 2013. Critics point to the company's massive buybacks as evidence that this is just financial trickery, "IBM continues to beat earnings due to cost management and stock buybacks, but there is just no growth strategy here."

IBM Shares Outstanding Chart

While partially true that EPS was boosted by the buybacks, (IBM's average share count has declined by 3.8% CAGR over the last 5 years due to $71.5 billion in buybacks), even when the buyback is accounted for, it only boosted EPS by about 5%, meaning 9% EPS growth was accomplished in 2013, during a very challenging year for the IT industry, a trough in the hardware replacement cycle.

Right now analysts and critics are piling on IBM arguing fear, uncertainty and doubt of all future growth prospects. "IBM is trying to figure out a way to grow Watson 100 fold over 10 years, which is a herculean objective. For a company that hasn't grown revenue in five years, that task may very well prove impossible."

In reality this downturn won't last forever. Management has already explained their strategy for selling off the declining hardware sectors, (see the recent X86 sale to Lenovo for $2.3 billion) and is reinvesting into the higher margin software, security, analytics and cloud services. The margins on software can be as high as 90%, and the company is experiencing success with its Smarter Planet, (sales up 20%) business analytics, (up 9%) cloud services, (up 69%) and security software, (up double digits).

The thing that most analysts fail to take into account is that IBM, like Mr. Buffett, plays a long game, indeed that is why he bought such a large stake in the company and even wrote in his 2011 shareholder letter, "We should wish for IBM's stock price to languish throughout the [next] five years."

Whereas Wall Street measures success quarter by quarter or year by year, Mr. Buffett measures success over 5, 10, 20 years. This is the same kind of time frame IBM works on. They are a multi-generational company, and if investors are willing to think on the same time scales as IBM and Mr. Buffett, then IBM can prove to be richly rewarding to them as well. This is because the recent, short-term hiccup in IBM's growth plan, has left the company trading at a deep discount to its intrinsic value.

Using a discounted cash flow analysis utilizing the latest EPS from the Q4 earnings report, ($16.28), and modeling 8.86% growth over 5 years, 6% for an additional 19 years, (this is the CAGR for IBM's EPS over the last 19 years) and discounting to 9%, the long-term CAGR of stock market, we get a fair value of $316.31, with a 42% margin of safety. What's more, using reverse DCF, we see that the market is currently pricing IBM for -3.7% growth. Given that the same analysts that are lamenting the last year's sales declines are expecting 9% EPS growth in 2014 and 11% in 2015 and 8.67% over the next 5 years, it seems clear that the current valuation represents an opportunity. However, how much of an opportunity?

There are a few ways to model this. First, take management's guidance of $20 EPS in 2015 and multiply by IBM's 5-year average P/E, which is 14.27. This gives us a 2-year price target of $285.40. Add to this the next two years of dividends, (which I'll model in a second), and you get a total return of $293.52, representing a 26.74% CAGR, (jumps to 29% with dividend reinvestment).

Next we can model out potential 5-year performance using the same method as before. Using 8.67% annualized EPS growth for 5 years we get 2018 EPS of $22.84. Multiply by the anticipated P/E of 14.27 to get $325.92. Dividends are modeled as growing 13.7% annually, (the CAGR growth rate for IBM's dividends over the last 5 years). This results in 5 years of dividends coming to $24.97 and brings the 5-year total return share value to $350.89. This is a 92% return or 13.9% CAGR. Reinvesting dividends raises that to 16% CAGR. Overall, this is a very strong potential return.

However, IBM is primarily a dividend growth stock so we can also model its potential 5-year return through a dividend analysis. The average 5-year yield is 1.8%. The current 2.1% yield indicates that IBM is trading at a 20% discount to its 5-year yield. By modeling 13.5% annual growth in dividends, we get 2018 dividends of $6.35/share, a payout ratio of 27.8% and assuming a 1.8% yield, a share price of $352.78. Add in the dividends received, and the total share value is $377.75, representing a 5-year 107% return. This is 15.7% CAGR and if dividends are reinvested, jumps to 17.7% CAGR. Keep in mind that none of my assumptions are wild, pie in the sky speculations. Merely by using conservative, historically achieved estimates of future growth and dividend growth, we get 5-year total returns of between 13.9-17% CAGR depending on whether or not one treats IBM as a pure growth stock, a pure dividend growth stock or a mixture of the two. It also depends on whether or not you reinvest the dividends, but regardless, those potential returns represent historically market smashing returns and could easily prove to be conservative if management can execute their turnaround plan and grow EPS by greater than just 8.7% over the next 5 years.

A quick look at technical analysis to determine whether or not IBM's near-term price is likely to decline indicates that the recent $10/share rally, (slow stochastics peaking at over 80, with RSI at 70 and starting to turn downward) indicates that IBM may soon return to around $170/share. On the other hand, MACD shows increasing positive price momentum and given how undervalued this stock is, it would be wise for interested investors to at least initiate a half position, adding on any further dips that may occur over the next few weeks.

In summary, IBM is one of the oldest and most dependable of the dividend growth stocks available today. The recent market overreaction to a cyclic downturn in the IT industry's hardware replacement cycle leaves patient, long-term investors with a chance to achieve strong, market crushing returns, while buying at a 42% margin of safety.

Source: IBM: Buyback And Dividend Growth King At 42% Margin Of Safety