- IBM undervalued according to almost all reasonable metrics.
- Competitive advantages remain intact.
- Emphasis on new products and services likely to generate significant growth.
- Current slowdown in revenue and earnings growth likely to prove temporary.
We are advocating taking a long-term investment position in IBM (NYSE:IBM). While the company's revenue growth has recently come to a halt, probably due to temporary reasons, its competitive advantages and long-term prospects remain as bright as ever. Pessimism and uncertainty has generated a clearly inexpensive valuation and a window of opportunity for the savvy buyer of quality stocks.
Industry & Trends
IBM operates in the IT industry through hardware production, software and delivery of consulting services. During the last 30 years, the industry has grown in a spectacular way and everything points to a continuation, or even acceleration of this trend.
The steady increases in computing power, miniaturization and communication create constantly new and better applications for technology. IT innovation was once confined to developed countries, but is rapidly becoming ubiquitous in the emerging world as well, another source of sustained growth.
IBM is one of the largest IT companies with an array of offerings, including system hardware, infrastructure software, outsourcing, and systems integration services. The firm has operations in more than 170 countries and generates about 65% of revenue from abroad.
Each business line taken individually would already be impressive, but IBM characteristically leverages on all three to provide complete IT solutions for its clients, typically large enterprises. IBM's typical client would use IBM mainframes and servers, have IBM provide infrastructure software and hire IBM consulting services to integrate solutions to the firm's individual business model and to manage the smooth function of the systems.
This integration can be highly beneficial to IBM's customers with the convenience of a one-stop-shop for all of their IT needs. It also creates significant client stickiness as IBM's presence becomes deeply embedded into the client's business practices. A significant proportion of IBM's revenue derives from long-term supply agreements, predictable and recurring.
Lately, IBM has targeted a few areas for aggressive growth, namely the cloud, big data & analytics, smart planet, mobile and social media. These concepts were not invented by and are not exclusive to IBM, but the firm is proactively leveraging on these items to provide practical business solutions to its clients with a clarity and focus that I have yet to see in most of its competitors.
IBM can boast a particularly powerful set of intrinsic characteristics that give it an enduring competitive advantage.
Patents & IP: IBM consistently tops the list of patent recipients each year.
Economies of scale: IBM is one of the world's largest IT companies and can outspend rivals in R&D and marketing expenses, while keeping costs low as a percentage of revenue.
Customer captivity: clients find it difficult and risky to leave IBM after using its products and services. Search in IT costs are high and switching is extremely expensive, time consuming and dangerous in terms of possible loss of data, compatibility or smoothness of operations.
Brand: IBM being a trusted brand makes it a favorite among IT personnel that prefer a premium name for mission-critical systems.
The combination of the factors above guarantee IBM's staying power and earnings predictability for the long-term future.
IBM's financial position is excellent, with about $11bn in cash. The outstanding long-term debt of about $33bn, a manageable 1.3x EBITDA, is almost fully backed by $30bn of finance receivables. The company has stable and predictable earnings flow, which could allow higher gearing ratios if needed.
During the last 10 years, IBM has been growing revenue and earnings per share at 6% and 12% respectively. The company redistributes through dividends and buybacks about 60% of cash flows and reinvests the rest, mainly in new acquisitions. Return on equity has reached 68% in 2013, up from 27% 10 years ago. Operating margins have been expanding too from 16.6% to 24.5%. These improvements in operating metrics are due to IBM's strategy of divesting low margin, low-growth businesses in favor of higher margin, higher-growth segments.
IBM can boast an outstanding management team based on the following observations:
Competence: management has succeeded in navigating successfully a number of major industry transitions while preserving profitability and increasing the company's strategic advantages. For example, IBM was one of the first firms to accurately predict the commoditization of the PC, promptly selling off its PC business to Lenovo. The current focus on software, cloud, mobile, big data & analytics, confirms that management is aware of future trends and is being pro-active in addressing them.
Honesty: IBM's management team has been extraordinary with respect to integrity and transparency. The company is extremely clear and informative in its reporting, typically offering a surprisingly high level of granularity in its communications to investors. Long-term targets and plans are set and regularly met. In 2013, the management team has decided to forego its annual bonus due to lackluster results, especially on the revenue side. This shows a level of integrity above the average S&P 500 company.
Shareholders' friendliness: this is clear, for example, from IBM's share buyback policy.
The company has halved the number of shares outstanding in the last 15 years. IBM also pays an adequate dividend. Capital allocation seems to be sensible, as past acquisitions show strategic sense and delivered adequate return on capital.
IBM is undergoing a period of transition. The rise of the cloud, in particular, has disrupted the IT industry, decreasing or shifting the demand for IBM hardware, as companies may effectively outsource their IT needs to cloud providers (which typically use their own hardware). This transition may also partially reduce the demand for some of IBM services and software.
A slowdown in emerging markets' economies, coupled perhaps with suspicion about the Snowden revelations, have also drastically reduced demand for IBM products. These factors seem to explain IBM's stagnating revenue and profit (despite increasing per share figures thanks to buybacks) and a lagging stock price.
As disturbing as the situation can be, there is a good chance that the above factors will eventually resolve in IBM's favor. IBM seems to have fully grasped the importance of the cloud (of late) and has complemented its cloud offering with well-targeted acquisitions and good integration with the rest of the product offering. From a relatively small base, IBM cloud offerings are growing at high double-digit rates and accounted for $4.4bn of revenue in 2013.
IBM is a technology company and is subject to a faster rate of change than, say, a company operating in the food & beverage industry. Paradigm shifts, such as the cloud, frequently pose a risk if the company fails to address them timely and correctly.
IBM's hardware business, as mentioned earlier, is undergoing a process of commoditization and is vulnerable to competition from lower-cost competitors, e.g. Lenovo and others. This is actually an ongoing issue, but IBM seems to be tackling it correctly, migrating to higher value-added segments and divesting lower margin, lower-growth areas.
Software and consulting divisions carry some competition risk as well, although we believe that the company's brand name and comprehensive product offering represent strong mitigating factors.
Other risks, such as emerging markets slowdown, protectionism or foreign currency, are temporary and shouldn't alter our long-term view.
Companies with stable earnings patterns are easy to value. IBM closed the year 2013 with earnings per share of about $15. Its historical median P/E is about 15x, which would place the company's fair value at around $225, a 20% premium to yesterday's stock price. We believe 20% represents a good margin of safety for a solid company like IBM.
According to our projection, IBM can easily meet a long-term EPS growth rate of at least 10%. Investors may therefore expect a 20% upside from multiple reversion to historical mean, a 10% yearly growth rate from increasing EPS and a 2.2% dividend rate. It is fair to say that long term IBM returns going forward should be north of 12% CAGR.
As of March '14, the S&P 500 P/E ratio is almost 20x. IBM P/E is 37% lower (12.7x). The company is financially sound, adequately managed, protected by sustainable competitive advantages and likely to grow steadily in the future.
Yes, there are some issues such as revenue stagnation, a stall in growth from emerging markets, declining hardware and a paradigm shift to the cloud.
However, buying fundamentally solid companies, at bargain prices, due to temporary reasons is quintessential value investing and that is why we advise to take a position.