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Summary

  • IBM has not been doing well recently – it fell approximately 10% from March 2013 and is about 8% off its 52-week high.
  • Through analyzing its fundamentals, I discovered that IBM is undervalued by approximately 7%.
  • This implied valuation is supported by conservative growth assumptions regarding its revenue, expenses and capital expenditures.

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Source: Google Finance

As seen above, International Business Machines (NYSE:IBM) has performed poorly since March 2013 - falling approximately 10%.

In this article, I will be analyzing IBM's fundamentals to conclude if this fall in its stock price is warranted, and ultimately whether IBM is overvalued, undervalued or fairly valued on a fundamental basis.

As most of you would know, valuations of companies are performed based on their future earnings potential. Hence, in order to form valid and defensible assumptions regarding a company's growth prospects, it is paramount to analyze a company's historical financials to get a gauge of how a company has performed in the past and an idea of how it will perform in the future.

Historical financials

All figures are in millions of USD, except for per share data.

Source: SEC Filings

As seen above, IBM's service revenue has declined at quite a steady rate, -2.1% in 2012 and -3% in 2013.

On the other hand, IBM's sales revenue has declined at a faster pace compared to its services -2.4% in 2012 and -6.9% in 2013.

As for its financing revenue, it has lagged in 2012 - decreasing 4.3% year-over-year, but rallying in 2013, where it grew 0.3%.

Thus, total revenue declined by 2.3% and 4.6% in the years 2012 and 2013 respectively.

Source: SEC Filings

As seen above, IBM's cost of service revenue has grown as a percentage of total sales in recent years. It has increased from 38.1% of sales to 40.5% from the years 2011 and the first quarter of 2014.

As for its cost of sales revenue, it has hovered around 14% and 11.4% of total revenue in the years 2011 to FY2014 Q1.

As for its cost of financing revenue, it has remained steady in recent years, ranging from 1% to 1.2% of total revenue.

Thus, by subtracting costs from total revenue, we arrive at gross profit, which has hovered between 46.9% and 48.6% of total sales in the years 2011 to FY2014 Q1.

Hence, we can conclude that in recent years, IBM has been experiencing a decline in revenue, a sign that it is starting to lose its competitive position.

Source: SEC Filings

As seen above, SG&A expenses have increased from 22.1% to 28% of total revenue from the years 2011 to the first quarter of 2014. However keep in mind that since we only have data for the first quarter of 2014, SG&A expense is skewed to a higher percentage. In all likelihood, it will plateau at around 23% as more information regarding IBM's performance in fiscal year 2014 is released.

R&D&E expenses have been hovering around 5.9% to 6.7% of total revenue. This increase in R&D&E spending as a percentage of sa is justified by the company in its 2013 annual report where they state that they are heavily increasing investment in R&D&E, especially big data analytics, in an effort to increase future revenue-generation potential.

IP and custom development income have been near-zero in historical years, ranging from 0.8% to 1% of total sales.

Other income has similarly been close to zero in recent years, hovering from 0% to 0.8% of total sales.

Interest expense has increased from 2011 to FY2014 Q1, from 0.4% to 0.5% of total sales.

Hence, by summing these line items, we arrive at total expenses which has been ranging from 27.3% to 33.6% of total revenue. Keep in mind that this range is skewed due to IBM only having released financial information for FY2014 Q1.

Source: SEC Filings

As seen above, by subtracting total expense from gross profit, we arrive at pre-tax income, which hovered between 13.3% and 21% of total revenue, but will likely even out at approximately 20% of total revenue as fiscal year 2014 ends.

IBM as a whole, operates in more than 175 countries around the globe and its tax rate has fluctuated wildly between 15.6% and 24.5% of pre-tax income.

By subtracting taxes from pre-tax income, we arrive at net income, which has ranged from 10.6% and 16.5% of total sales, and more than likely to even out at 15% as fiscal year 2014 goes on.

IBM's EBIT margin has ranged from 13.7% to 21.4% of total sales. EBITDA margins range from 18.8% to 25.9% of total revenue. EBIAT margin range from 11% to 16.9% of total revenue, with the above disclaimer still applying.

Source: SEC Filings

As seen above, depreciation has hovered steadily between 3.1% and 3.6% of total sales.

Amortization of intangibles, stock-based compensation deferred taxes and net gain/loss on asset sales have similarly remained steady at 1.2% to 1.5%, 0.6% to 0.7%, -1.5% to 1.2% and -0.2% to -0.7% of total revenue, respectively.

Thus, net adjustments to non-cash charges have hovered between 3.2% and 6.4% of total revenue.

Source: SEC Filings

As seen above, receivables, retirement-related liabilities, other assets/liabilities and accounts payable have all been relatively steady, ranging from -1.3% to -2.1%, -0.8% to 0.3%, -0.1% to 0.3%, -0.5% to 0.5% of total revenue, respectively.

Hence, net changes to working capital has remained steady at -2.3% to -2.7% of total revenue.

Since IBM's net changes to working capital is a negative number, this signifies a cash outflow, and raises the obvious question - whether this use of cash is warranted. Thankfully, this is answered by the company through its annual report, where it mentions it is making continual investments to high-growth segments of the markets that it serves, especially big data analytics.

Source: SEC Filings

As seen above, capital expenditures have remained relatively steady, ranging from -3.4% to -4.1% of total revenue.

By adding non-cash charges, changes to working capital and subtracting capital expenditures from EBIAT, we arrive at unlevered free cash flow, which has decreased over the years from $16.7bn in 2011 to $13.5bn in 2013.

At face value, one would assume a bearish view of IBM due to its decreasing free cash flow in recent years. After all, many invest in IBM due its steadily increasing dividends. If free cash flow continues to decrease, the company would find it harder and harder to increase its dividend.

However, through combing its financial statements, the main reason for IBM's decreasing free cash flow is due to payments of taxes. Hence, this decrease in free cash flow is not nearly as concerning as one might think, at first sight.

Projected financials

Now that we have established a platform we can use to form valid and defensible assumptions regarding IBM's future growth, we can proceed to projecting future financials.

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Source: SEC Filings, author's own estimates

As seen above, for services, sales and financing revenue, I have projected them to grow by 2.5%, 5% and 2% respectively, year-over-year. These are conservative assumptions considering the potential for growth in these segments of the IT industry

Thus, I project that IBM's total revenue will increase by approximately 3.5% year-over-year from 2015 to 2019. In other words, IBM's total revenue is projected to increase from $103bn in the year 2015 to $118bn in the year 2019.

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Source: SEC Filings, author's own estimates

As seen above, I have projected cost of services, sales and financing to be 38.4%, 12.8% and 1.1% of total revenue going forward. These numbers were derived from an average of the previous historical years.

Thus, total costs are projected to remain steady at 52.4% of total revenue going forward, increasing from $54bn in 2015 to $62bn in 2019.

Hence, gross profit is projected to remain steady at 47.6% of total sales going forward, increasing from $49bn in 2015 to $56bn in 2019.

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Source: SEC Filings, author's own estimates

SG&A, R&D&E, IP and custom development, other (income) and expense and interest expense, are projected to be 24%, 6.2%, -1%, -0.4% and 0.4% of total revenue going forward, respectively.

Thus, total costs are projected to be 29.3% of total sales going forward, increasing from $30bn in 2015 to $34bn in 2019.

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Source: SEC Filings, author's own estimates

By subtracting expenses from gross profit, we arrive at pre-tax income, which is projected to be 18.4% of total sales going forward, increasing from $18.9bn in 2015 to $21.7bn in 2019.

Taxes are projected via utilizing the average of IBM's historical tax rate from 2011 to FY2014 Q1, giving us a tax rate of 21.1% going forward.

By subtracting taxes from pre-tax income, we arrive at net income, which is projected to be 14.5% of total sales going forward, increasing from $14.9bn in 2015 to $17.1bn in 2019.

EBIT, EBITDA and EBIAT margins are projected to be 18.8%, 23.5% and 14.8% going forward.

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Source: SEC Filings, author's own estimates

As seen above, depreciation, amortization of intangibles, stock-based compensation, deferred taxes, and net /loss on asset sales and other non-cash charges are projected to be 3.4%, 1.3%, 0.6%, -0.1% and -0.5% of total sales going forward, derived from the average of IBM's historical numbers. This gives us a net adjustments to non-cash charges figure of 4.8% of total sales going forward, increasing from $4.8bn in 2015 to $5.5bn in 2019.

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Source: SEC Filings, author's own estimates

As seen above, changes to receivables, retirement-related liabilities, inventories, other assets/liabilities and accounts payables are projected to be -1.6%, -0.7%, 0.02% and -0.1% of total revenue going forward. Hence, net changes to working capital are projected to remain steady at -2.4% of total sales going forward, increasing from $2.5bn in 2015, to $2.8bn in 2019.

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Source: SEC Filings, author's own estimates

As seen above, capital expenditures is projected to be a little on the high side, 3.8% of total sales going forward, increasing from $4.2bn to $4.8bn in the years 2015 to 2019.

Thus, unlevered free cash flow is projected to increase from $13.7bn in 2015 to $15.7bn in 2019.

These free cash flow figures are then discounted to the present using a weighted-average cost of capital ("WACC") of 8.4%, derived from taking the after-tax cost of debt and cost of equity calculated using the capital-asset pricing model ("CAPM"), and then summed up to value IBM 5 years into the future.

As IBM is assumed to continue existing after 5 years into the future, I have calculated a terminal value using a WACC of 8.4%, and a conservative growth rate of 3.2%. This terminal value is then discounted to the present.

Next, I arrive at enterprise value by adding the present value of the sum of free cash flows to the present value of terminal value. After deducting net debt, preferred stock, and non-controlling interest, I arrive at an equity value of $218bn, i.e. an implied share price of $209.90, which represents a 7.6% increase from its current share price of $195.11.

Conclusion

Even with conservative assumptions on IBM's future revenue growth (3.5% year-over-year total revenue growth), and slightly harsh assumptions regarding capital expenditures (3.8% year-over-year, compared to 3.4% in FY2013), IBM still shows to be undervalued by 7%.

Furthermore, IBM is known for its aggressive share buyback programs, which I have not factored in yet. Naturally, having a lower number of shares outstanding increases a company's share price.

Most might be concerned regarding my revenue projections as they are one of the key drivers of value. My revenue projections are supported by numerous industry projections. Also, two of the segments that IBM is heavily investing in, namely big data analytics and cloud services, are growing at an unprecedented pace compared to the overall IT market. The IDC & IIA predicts that big data will grow 6 times faster than the overall IT market while a cloud computing study estimates that the cloud computing market will grow at a 36% compound annual growth rate through 2016.

In summary, I feel that IBM is slightly undervalued by investors and that this represents a decent buying opportunity for investors looking for a company with solid fundamentals and decent growth potential.

My analysis of IBM on Excel can be found here.

Source: The Bull Case For IBM