IBM (NYSE:IBM) has caught the eye of many well-seasoned investors traditionally that have avoided technology due to the sector's opaqueness and rapidly-changing industry forces. For one, Warren Buffett has long avoided technology, famously dodging the dot-com bubble. But Big Blue has managed to lure the Oracle of Omaha into a false sense of security with its operating earnings-per-share target of at least $20 by 2015. After all, it's reasonable for the Oracle to assume that IBM should garner at least a 10 times earnings multiple at that time, so any price below $200 ($20 x 10 times) would serve as a decent margin of safety. Though this makes sense for companies growing the top line, IBM is not and the company's EPS target is driving management to destroy shareholder value. Let's talk about why this is the case, derive IBM's cash-flow based intrinsic value estimate, and run shares through the Valuentum style of investing.
For those that may not be familiar with our boutique research firm, we think a comprehensive analysis of a company's discounted cash flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to the portfolios. These stocks have both strong valuation and pricing support. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.
Most stocks that are cheap and just starting to go up are also adored by value, growth, GARP, and momentum investors, all the same and across the board. Though we are purely fundamentally-based investors, we find that the stocks we like (underpriced stocks with strong momentum) are the ones that are soon to be liked by a large variety of money managers. We think this characteristic is partly responsible for the outperformance of our ideas -- as they are soon to experience heavy buying interest. Regardless of a money manager's focus, the Valuentum process covers the bases.
We liken stock selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree. That's why we focus on the DCF -- that's why we focus on relative value -- and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than the Valuentum process. They call this way of thinking common sense.
At the methodology's core, if a company is undervalued both on a discounted cash flow basis and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores high on our scale. IBM posts a Valuentum Buying Index score of 7, reflecting our "fairly valued" DCF assessment of the firm, its attractive relative valuation versus peers, and bullish technicals (which have soured just a bit in the past week or so). We say that IBM is fairly valued because it falls with our 'fair value range,' but our point estimate of its fair value ($182) has been meaningfully below its share price for some time. The company last traded at our fair value estimate in February -- meaning all the share buy backs completed above its fair value (in order to hit 'earnings-per-share' targets) have destroyed shareholder value (learn more about how to determine if share repurchases are value-creating here). With your attention, let's now dig into IBM's report.
IBM's Investment Considerations
- IBM's business quality (an evaluation of our ValueCreation™ and ValueRisk™ ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders with relatively stable operating results for the past few years, a combination we view very positively. Even though management is focused on EPS (a classic 'no no'), IBM still has a valuable Economic Castle.
- IBM solves business problems via integrated hardware/software solutions that leverage IT and its knowledge of business processes. Its solutions help reduce a client's costs or enable new capabilities that generate revenue. Warren Buffett owns ~6% of the firm.
- IBM has a good combination of strong free cash flow generation and manageable financial leverage. We expect the firm's free cash flow margin to average about 21.2% in coming years. Total debt-to-EBITDA was 1.7 last year, while debt-to-book capitalization stood at 63.5%.
- We like the firm's high-margin $140 billion services backlog, but fundamentals have been waning in recent periods. Revenue and operating income have faced pressure, and the company has mitigated the declines via low-quality share buybacks. We're a bit uncomfortable that its 'growth markets' revenue continues to decline.
- IBM has ambitious plans to reach $20 in operating earnings per share by 2015 via a combination of revenue expansion, operating leverage, and share repurchases. If the firm doesn't hit that mark, it won't be far from it thanks to share buyback flexibility.
- IBM registers a 7 on the Valuentum Buying Index. We'd only grow interested in the shares if they were to register a 9 or 10 (a "we'd consider buying" rating) on the index. We include highly-rated firms in the Best Ideas portfolio.
- Big Blue pays a nice dividend, posting a yield of 2.4%. The company has a solid Valuentum Dividend Cushion, a fundamental cash-flow-based measure of a firm's dividend health.
When IBM announced that it had bought back a staggering $8.2 billion worth of shares during the first quarter of 2014 in its quarterly report, we were shocked. IBM's management is doing more to destroy shareholder capital than it is doing to generate economic value at this juncture. We don't think Warren Buffett (BRK.A, BRK.B) will stick around much longer with his 6% stake if fundamental operations continue to deteriorate and especially if management continues to pursue value-destroying activities in order to achieve self-enforced, near-term earnings-per-share goals. Warren Buffett likes economic moats, but he also focuses very much on incremental returns on capital and the uses of a firm's excess cash. IBM is failing miserably in the latter two considerations.
Big Blue's first-quarter results revealed a 1% adjusted decline in revenue, and a whopping 22% decline in operating (non-GAPP) income. The buybacks slowed the decline to 15% on a diluted earnings per share basis, but clearly the results weren't up to expectations. Perhaps the only bright spot in the quarter was that services backlog of $138 billion advanced modestly, but only after adjusting for currency and excluding its divested customer care outsourcing business. More startling was that revenues from the company's growth markets decreased 11% (down 5%, adjusting for currency), with aggregate declines in Brazil, Russia, India, and China falling at a similar pace.
Looking forward, IBM continues to expect full-year non-GAAP diluted earnings per share of at least $18 in 2014, but this target is losing its luster as share buybacks mount at value-destructive prices and the company benefits from favorable and unexpectedly-low tax rates. We would like management to reconsider its earnings-per-share focus, and instead apply its faculties to distancing incremental return on invested capital to levels far above the company's cost of capital, thereby generating economic value for shareholders. At this juncture, IBM's performance continues to be of low quality. We do not believe IBM will offer another earnings-per-share target after this one.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. IBM's 3-year historical return on invested capital (without goodwill) is 66%, which is above the estimate of its cost of capital of 9.9%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. IBM's free cash flow margin has averaged about 13.9% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At IBM, cash flow from operations decreased about 12% from levels registered two years ago, while capital expenditures fell about 11% over the same time period.
Our discounted cash flow model indicates that IBM's shares are worth between $146-$218 each. Shares are trading at the high end of the range, just above the midpoint. The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. Though the range appears to be large for a company like IBM, we think it appropriately captures its range of future outcomes (both upside and downside).
The estimated fair value of $182 per share represents a price-to-earnings (P/E) ratio of about 12.2 times last year's earnings and an implied EV/EBITDA multiple of about 9.8 times last year's EBITDA. Our fair value is completely cash-flow based. The model reflects a compound annual revenue growth rate of -0.4% during the next five years, a pace that is lower than the firm's flat 3-year historical compound annual growth rate. We think this may even be optimistic in light of the company's growth markets, which are shrinking, offset in part by the firm's burgeoning services backlog. Our valuation model reflects a 5-year projected average operating margin of 24.7%, which is above IBM's trailing 3-year average. We think IBM will have to be laser-focused on costs to achieve its bottom-line EPS targets, particularly in a declining revenue environment. We give it some wiggle room in this area.
Beyond year 5, we assume free cash flow will grow at an annual rate of 0.5% for the next 15 years and 3% in perpetuity. For IBM, we use a 9.9% weighted average cost of capital to discount future free cash flows. The firm's long-term growth rate is consistent with a company of IBM's size and indicates a return to growth at Big Blue; its discount rate approximates the median in our coverage.
We understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money managers -- those that drive stock prices -- pay attention to a company's price-to-earnings ratio and price-earnings-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. For relative valuation purposes, we compare IBM to peers Hewlett Packard (NYSE:HPQ) and Apple (OTC:APPL), among others in its industry group. IBM is priced attractively on a PE and PEG basis, but these favorable comparisons are driven more by share buyback activity than any fundamental improvements.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $182 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for IBM. We think the firm is attractive below $146 per share (the green line), but quite expensive above $218 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate IBM's fair value at this point in time to be about $182 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of IBM's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $233 per share in Year 3 represents our existing fair value per share of $182 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements
In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within 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.
Additional disclosure: AAPL is included in the actively-managed portfolios.
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