IBM: Cheap, But The Chart And Cloud Exposure Are Concerning

|
 |  About: International Business Machines Corporation (IBM), Includes: AMZN, LNVGY, MSFT, ORCL, SAP
by: Brian Grosso

Summary

I will begin spending one hour of preliminary research on companies I am interested in, looking for reasons not to invest before delving any further.

I began doing so by studying IBM.

Software and GBS segments have significant competitive advantages, but GTS is exposed to the move from private to public cloud storage, whereby data storage is becoming a commodity business.

IBM stock has reached $175 three times in the last year. I would feel far more secure getting that price, and see a move back to $175 as possible.

I am avoiding the stock for now, but set a price alert at $176.

An excellent article by Investing 501 offers some advice that had an impact on me:

Our experience has led us to conclude that the old "80-20 Rule" works pretty well for us when it comes to doing investment research. 80% of what we need to know to make an investment decision comes in the first 20% of the time we spend on the idea. This is why we recommend the "one-hour" analysis approach.

I have found that your investment process should be focused on becoming better than others at measuring and understanding value and not on trying to generate superior information.

There is no substitute for experience.

As a busy college student with an interest in the markets but relatively little experience, I often find myself questioning:

  • How I can expose myself to more businesses to the point of understanding
  • How I can streamline my investment research process to do as much of the above as time-effectively as possible

One hour of preliminary research on a variety of companies seems like a solid solution. I don't think that is enough time to know for sure whether something is a worthwhile investment, but because of my strategy of portfolio concentration (only own 1-3 stocks at a given time), I tend to be very skeptical of ideas, and one hour should be enough to know if a company is not a worthwhile investment. Charlie Munger has surely said this at some point:

A great way to be smart, is to not be stupid.

On that note, I will be putting various ideas through the wringer for an hour before delving any deeper.

I will kick off the series with IBM Corp. (NYSE:IBM).

Economics

I was turned on to IBM because it is Berkshire Hathaway's 4th-largest partial holding at 6.56% of the company, worth almost $13B. It was also selected by Buffett himself, not Weschler or Combs, and Buffett made an exception to his "Don't invest in tech because it's not in my circle of competence" personal restriction to buy IBM, so he must feel very strongly about it. Buffett normally avoids tech, because he feels technological changes are inevitable and happen quickly, making the stable/sustainable competitive advantages he desires hard to come by. In explaining his investment in IBM, he has argued that it is more of a consulting/business processes firm than a technology company, and I sort of understand that, but I don't think it is completely true.

The company is involved in many different businesses. 48.3% of 2013 EBIT came from Software, 30.4% from Global Technology Services, and 13.9% from Global Business Services (the remaining few percent from less relevant segments).

Software consists mostly of branded middleware. Wikipedia defines middleware as:

The software layer that lies between the operating system and applications on each side of a distributed computing system in a network.

It seems to be the infrastructure for large-scale enterprise applications. Two-thirds of Software revenue is recurring, and one-third is OTC (one-time contract)-based. From the Q1 2014 CC:

This is the 13th year in a row that Gartner named IBM the market share leader in application infrastructure and middleware software, and with 30 % market share, we are nearly double the size of our closest competitor.

The success of Microsoft's (NASDAQ:MSFT) Office and Windows software lines are evidence that competitive advantages are very achievable in software. Network effects play a role. Clients get used to using a specific software and become price-inelastic, at which point, the software is "sticky." From the 2013 10-K:

The key competitive factors in this segment include: functionality, ease-of-use, scalability, open standards, total cost-of-ownership and business value.

Note that cost is listed fourth. It seems to be a price-inelastic business.

Software is a business where intellectual property protection seems to be stronger than in other areas of technology. IBM has a ton of patents, and continues to be awarded more than any other company:

In 2013, IBM was awarded more U.S. patents than any other company for the 21st consecutive year. IBM's 6,809 patents awarded in 2013 represent a diverse range of inventions poised to enable significant innovations that will position the company to compete and lead in strategic areas such as Watson, cloud computing and big data analytics. These inventions also will advance the new era of cognitive systems where machines will learn, reason and interact with people in more natural ways. It was the most U.S. patents ever awarded to one company in a single year.

Leading market share by a wide margin and mostly recurring revenue in a price-inelastic and IP-driven business, IBM's Software business seems to have significant competitive advantages. The business faces high-quality competition in Oracle (NYSE:ORCL), Microsoft, and SAP AG (NYSE:SAP), and I am concerned that IBM has been reducing R&D lately, but I think the Software business has a solid competitive position.

Global Business Services consists of consulting and application management services. Application management seems to be along the same lines as the company's Software division, and consulting is a people & expertise-driven business that I think is also open for differentiation. This also seems to be an area that can leverage the IBM brand. Other pure-play consulting businesses like Bain and McKinsey seem to live and die by their reputations, and have a significant ability to differentiate themselves, as a result. For that, I like the economics of this segment. IBM has the necessary brand strength, and can sell itself as a tech processes-oriented consultant. It can also easily cross-sell this business with middleware. For that, I like the economics of this segment as well.

Global Technology Services primarily provides IT infrastructure, i.e. data storage and management through public and private cloud. Companies increasingly need to store, easily access, and protect large amounts of data. Traditionally, this has been done through "private" servers located on-site, looking something like this.

Recently, there has been a move towards the "public cloud" though, where one company has a ton of these servers and sells storage to other companies. The public cloud is typically cheaper compared to the private cloud, because there is no need for on-site installation and the data is managed more efficiently (no idle/unused storage space). Maybe more important to cost reduction are economies of scale. Companies like Amazon (NASDAQ:AMZN) have been leading the charge in the public cloud. IBM has traditionally sold the private cloud, but does also offer public cloud servers. IBM has been resistant to the move to the public cloud, because it is far less profitable and more competitive. Amazon has characteristically been lowering cloud storage prices to breakeven levels, and everyone else now has the choice to follow suit or get out of the business. IBM has tried to sell the idea that the public cloud is not secure because it requires that data be transferred over the internet, whereas the private cloud can be accessed locally. I don't really buy that, though. I think the public cloud can be made secure if it isn't already, and the reduced costs probably far outweigh this concern anyway. The nature of data storage seems to make it ideal to become a commodity business. No matter what anyone says, there are only so many ways to store and access a byte.

IBM's EBIT in this segment grew in 2012 and was stable in 2013, but revenue has been declining. From the 2013 10-K:

IBM has a balanced history of exiting commodity businesses that no longer fit the high-value model while investing in strategic acquisitions and organic capabilities.

I believe data storage and management is quickly becoming a commodity business. My concerns about the economics of the business are beginning to show in the revenue decline in the segment and deceleration in EBIT growth. This being the second-largest contributor to consolidated EBIT, it is a very significant concern. I want to see the company deliver on its long-standing strategy of moving away from competitive/commodity businesses and transition away from this segment.

Recently, the company sold its x86 server business (standard private cloud, part of the GTS segment) to Lenovo (OTCPK:LNVGY) for a decent sum. This is good news, but I would like to see a continued and stronger push out.

Indicators

I already mentioned Berkshire's stake as playing a major role in my interest in the company.

Another reason the stock has my interest is that it has not participated in the run-up in US markets since the beginning of 2012:

This is really surprising to me. For one, IBM is a $190B blue-chip company that is a large contributor to the S&P 500 performance. Further, the nature of the business (enabling other businesses to operate efficiently and make more money) makes me think that IBM should be closely correlated with corporate America in general. If other businesses are doing better, shouldn't IBM as well? I think the US markets are pretty expensive at this point, and many investors agree with me. An investor I admire, David Tepper, attempted to exploit this by shorting the Russell 2000 and going long another seemingly cheap US blue-chip that has not taken part in recent market gains, Apple (NASDAQ:AAPL).

I am reluctant to short a major index, but I think the discrepancy between IBM's stock movement and the market is highly suggestive of value in the name.

Valuation

Because of IBM's significant and consistent share repurchases, the company is best valued on a per share basis. Because of one-time distortions like a large cash tax increase in Q1 2014, the company is probably better valued based on earnings than cash flow. Finally, because the company has made significant acquisitions recently and non-cash amortization of intangibles related to these acquisitions have hit the income statement, the company is probably better valued based on non-GAAP EPS, which excludes this than GAAP EPS. The company guided to $18 of non-GAAP EPS for 2014. At the current $187.06 quote, the stock trades at 10.4x that. I think that's pretty cheap for the attractive economics that exists in most of IBM's business and the company's per share growth track record and 2.35% dividend yield, but I think Mr. Market can offer me better, and I am reluctant to take a position at a double-digit multiple. The stock has reached the $170-175 level three times in the past year and showed strong support there each time.

The stock has also fluctuated around, such that I could easily see it moving back to that level. I think the stock is a decent buy here, but would be a real conviction buy 10% lower at $170.

Conclusion

I began my one-hour research series by studying IBM, and was generally impressed. My preliminary research does not preclude me from ever investing in the stock, but I did see enough to avoid the stock for now. I am impressed with the economics of the Software and GBS businesses, but the emergence of the public cloud is making data storage a commodity business, and IBM is still 30% exposed to this (by EBIT) through GTS. The stock looks cheap here, but I don't think this is the best price we'll see, and for that, I am avoiding it for now and setting a price alert at $176.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in IBM, AAPL over the next 72 hours. 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.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.