IBM Is Worth At Least $215

Mar.12.14 | About: International Business (IBM)

Summary

The percentage of IBM's recurring revenues has increased to 65%.

Applying a P/E multiple of 16 to the recurring portion of IBM's earnings already justifies the current market price.

This means that investors are getting IBM's cyclical business for free.

Last year, in my first article ever on Seeking Alpha, I laid out why International Business Machines (NYSE:IBM) should be worth at least 16 times earnings, based on the high percentage of recurring revenues the company enjoys. Splitting IBM virtually 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 - we can calculate a fair price/earnings ratio for the combined, actual IBM.

But first of all let's see how IBM's (unconsolidated) recurring revenue streams and pre-tax profits developed in 2013.

2013 ($ millions)

Pre-tax profit

Of which recurring

Recurring pre-tax profit

SEGMENT

GTS

6,983

60.0%

4,190

GBS

3,214

60.0%

1,928

Software

11,106

66.7%

7,408

S&T

-507

10.0%

-51

GF

2,171

66.7%

1,448

Total

22,967

65.0%

14,923

Click to enlarge

In financial 2013, the percentage of recurring profits has increased to 65%, which clearly is a positive development. (Although we have to remember that this increase is at least partly due to the loss recorded in the Systems and Technology segment, which has little recurring profits.)

Hence, earnings per share could be split as follows:

2013

$

Non recurring

Recurring

EPS (non-GAAP)

16.28

5.70

10.58

EPS (GAAP)

14.94

5.23

9.71

Click to enlarge

How much would IBM be worth, if it were split into two different businesses, one with only recurring, stable revenues, sticky client relationships and a strong brand - and another one heavily depending on global investment cycles, still a strong brand, but no recurring revenues at all?

Last year I proposed a multiple of 20 times earnings for the stable business and of 10 times earnings for the cyclical one. Some readers said, these multiples were too high. So let's see what happens, if we apply a multiple of 16 to the stable part and of 8 to the cyclical part:

Fair value calculation

Non recurring

Recurring

$

EPS (non-GAAP)

5.70

10.58

16.28

EPS (GAAP)

5.23

9.71

14.94

Fair PER

8.00

16.00

13.20

Fair value (non-GAAP)

45.61

169.25

214.87

Fair value (GAAP)

41.86

155.32

197.18

Click to enlarge

The fair value price/earnings ratio for the combined company in this case is 13.2. I would consider this figure to be an extremely conservative estimate. Remember that "recurring" means that these earnings are virtually certain to be delivered for several years to come and that IBM's cyclical operations include its wide-moat mainframe business. (Besides the fact that we are talking about a company that has registered more patents than anybody else in each of the past 20 years.)

Anyway, even applying such a conservative price/earnings ratio to the trailing Operating (non-GAAP) EPS figure, we can calculate a fair value for the combined company of $215. Even if we apply it to the trailing GAAP EPS figure, IBM is still worth far more than what it currently trades for on the stock market. At its peak in 2007, IBM actually traded at more than 16 times its current year Operating EPS.

(In his 2012 letter to shareholders Warren Buffett stated that analysts should focus on IBM's Operating EPS figure, so I don't think we should start a discussion on which EPS figure is more suitable.)

With the stock trading at $187, investors are paying about 16 times the recurring portion of IBM's forecast 2014 Operating EPS of $18 ($18 x .65 = $11.7), which basically means that they are getting the cyclical business for free.

Selling mainframes, semiconductors and storage devices may be a lumpy business and some people say, it will be dying slowly, yet I don't mind getting it for free.

Or, in other words, trading at only 10.44 times its forecast 2014 Operating EPS (which is highly likely to be delivered), the implied split valuation would be of just 6 times IBM's cyclical earnings plus 12 times its recurring earnings.

There is no way this could ever be a fair valuation for a market leading company with one of the strongest brands on the planet and a large, stable revenue base, hence in my opinion IBM is clearly undervalued at this point.

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.