- How to get IBM’s growth options for free.
- IBM maintains the ascending trajectory of its performance spread.
- IBM enhances its competitive advantage.
- IBM is roughly undervalued.
IBM (NYSE:IBM) is a remarkable value creator and enjoys a sustainable competitive advantage in enterprise software, services and hardware. However, IBM is not alone in the information technology services industry. Its close competitors, Oracle (NYSE:ORCL), Cisco Systems (NASDAQ:CSCO), Accenture (ACN) and Hewlett-Packard (HPQ), are also value creators, although Hewlett-Packard is just marginally one.
In the following analysis, we will show why, actually, you get IBM's growth options for nothing using our proprietary data and our own valuation methodology based on the integration of the economics of strategy and the principles of modern corporate finance.
International Business Machines
IBM operates in five segments: Global Technology Services, Global Business Services, Software, Systems and Technology, and Global Financing. GTS provides IT infrastructure services and business process services. GBS provides professional services and application management services. Software consists of middleware and operating systems software. Systems and Technology provides clients with business solutions requiring advanced computing power and storage capabilities. Global Financing invests in financing assets, leverages with debt and manages the associated risks. Total revenue, 12 months, December 31, 2013: $99.751 billion.
Oracle Corporation is a provider of enterprise software and computer hardware products and services. The company provides cloud services as well as software and hardware products to other cloud service providers, both public and private. The company's software business consists of two segments: new software licenses and cloud software subscriptions, and software license updates and product support. The company's hardware systems business consists of two operating segments: hardware systems products and hardware systems support. The company's services business consists of the remainder of its operating segments and offers consulting services, managed cloud services and education services. Total revenue, 12 months, May 31, 2013: $37.180 billion.
Cisco Systems, Inc. is the worldwide leader in networking for the Internet. Cisco's Internet Protocol-based networking solutions are the foundation of the Internet and most corporate, education and government networks around the world. Cisco provides the broadest line of solutions for transporting data, voice and video within buildings, across campuses, or around the world. Total revenue, 12 months, July 31, 2013: $48.607 billion.
Accenture is engaged in providing management consulting, technology and outsourcing services. The company's business is structured around five operating groups, which together consist of 19 industry groups serving clients in industries globally. The company's segment includes Communications, Media and Technology, Financial Services, Health and Public Service, Products and Resources. Total revenue, 12 months, August 31, 2013: $30.394 billion.
Hewlett-Packard Company is a provider of products, technologies, software, solutions and services to individual consumers, small- and medium-sized businesses and large enterprises, including customers in the government, health and education sectors. Its operations are organized into seven segments: the Personal Systems Group, Services, the Imaging and Printing Group, Enterprise Servers, Storage and Networking, HP Software, HP Financial Services and Corporate Investments. Total revenue, 12 months, October 31, 2013: $112.298 billion.
The IBM Strategy
The long-run operating strategy of IBM is to shift its portfolio to higher value software and services. Each year, IBM describes how the company manages its business and serves its shareholders. A long-term perspective ensures IBM is well positioned to take advantage of major shifts occurring in technology, business and the global economy.
For IBM, data is the new basis of competitive advantage because leaders will drive business outcomes by applying more sophisticated analytics across more disparate data sources in more parts of their organization, capture the time value of data by developing "speed of insight" and "speed of action" as core differentiators, and change the game in their industry or profession with cognitive capability. Therefore, IBM has built the world's broadest and deepest portfolio in data and analytics. In January 2014, it launched the IBM Watson Group to bring cognitive capabilities (built on technologies like machine learning, complex algorithms and natural language processing) to enterprises, institutions and individuals via the cloud. Also, the company has significantly increased analytics revenue through strategic investments, and new skills and capabilities. The company is remaking enterprise IT for the era of the cloud.
Creating value takes more than acceptance of value maximization as the organizational objective. All companies affirm to do this but that is not true. The choice of value maximization as the corporate objective must be complemented by a corporate vision, strategy and tactics that unite participants in the organization in its struggle for dominance in its competitive arena. That is clearly the case for IBM.
How does an investor determine if a company is creating value or not? As shown in the following table, the creation or destruction of value is measured by calculating the market value added over the past periods. Market value added will increase if value expands by more than the amount of new capital committed to the business, and vice versa. Mathematically, market value added is the market's assessment of the net present value of all investments the company has made, those already in place plus those expected to materialize in the future. It shows how successful management had been at allocating, managing and redeploying scarce resources of all kinds.
This behavior should give you assurance that the alpha you expect to obtain in investing in a particular stock will persist.
Market Value Added (as of May 23, 2014) (in Millions$)
Market Value of Total capital
|Market Value Added|
Companies that are leaders in value creation like the four fierce competitors above (IBM, Oracle, Cisco and Accenture) bring a different mindset and take a different approach to strategy development. They strive not just to be different from their competitors (which is necessary yet insufficient), but to be both different from and more profitable than their competitors, like IBM does. They realize that others will seek to copy their success. Therefore, they strive to develop capabilities and strategic assets that are hard to match.
Creating such distinctive strategies is a difficult challenge, and only a few companies in any given industry, like the ones above, are likely to be successful at implementing and sustaining them. From where the market value added comes from and how do you know that the company will continue to add market value in the future? Simply by looking at the performance spreads over time.
Sustainable Competitive Advantage
One of the keys to finding superior long-term investments is to buy companies that will be able to stay one step ahead of their competitors. Companies that have generated returns on their capital higher than their cost of capital for many years of operation usually have a competitive advantage, especially if their returns on capital have also increased over time. This line of reasoning is fundamental. In other words, having an unexpected or a temporary return on capital greater than the cost of capital is not enough for a business to be able to declare that it has a competitive advantage. Simply put, you cannot expect to obtain abnormal return (alpha) as an investor if the business you invest in does not have a sustainable competitive advantage. We define sustainable competitive advantage as the difference (the performance spread PS) between the return on capital and the cost of capital (a difference correctly measured, that is after transforming GAAP numbers into a rigorous computation of economic profit, after deducting the full cost of capital, and eliminating the accounting distortions). The higher the performance spread, the bigger the competitive advantage. In the table that follows, we present the performance spreads over time of the five competitors.
Performance Spread (Trailing 36 months) %
It is impressive to see that they all have positive performance spreads (PS), except for HP in the last year. For Accenture, to maintain a PS greater than 20 percentage points is remarkable. Oracle has also a noteworthy PS, but it has lost more than 7 percentage points in the last five years. Cisco and Hewlett-Packard (without much surprise), have also seen their competitive advantages eroding over time.
But the most prominent and stupendous fact in the above table is that, with its substantial size, IBM is able to increase its performance spread. It has gained 3 percentage points. Why is the IBM case outstanding?
As a long-term value investor, you know that, over time, market value and intrinsic value converge. A company with a positive performance spread (PS), that is a return on its capital greater than its cost of capital, a necessary condition for market value creation, will see it decrease to zero, if it is not able to embark on a new strategic value increasing trajectory. That is not the case for IBM (see above under "The IBM Strategy"). It means that IBM has a rock-solid position in enterprise software, services and hardware. The grouping of these services and products provides IBM with an unsurpassed solution creation and delivery ability that is the key to its positive and increasing performance spread. IBM product development and entrenched customer relationships ensure that it maintains, even enhances, its competitive advantage.
Equipped with the above information on performance spreads and the fact that we are in the presence of competitors that are also value creators, we have estimated the intrinsic value of those five stocks using the information above. They are presented in the second column in the following table. The comparison of the intrinsic value with the recent market price (third column) shows that IBM and Hewlett-Packard are exchanged at a price that is lower than their intrinsic value. The opposite situation prevails for Oracle, Cisco and Accenture. However, IBM is roughly undervalued and our simulations (not presented here) allow us to assert that this is indeed the case.
A superficial knowledge of how prices are established in the capital markets and an over confidence on a point estimate of the intrinsic values would cause some analysts to declare that Oracle, Cisco and Accenture are overvalued, and Hewlett-Packard is undervalued. We are not going that far and take these results as simply supporting our overall analysis: You get IBM's growth options for nothing. What do we mean by this and what confidence do we have in our estimations presented so far?
Intrinsic or Fundamental Risk
To answer these questions, we need to recall that the value of any company (i.e., the market value of total capital) is composed of two parts: the value of assets in place, [Va] or, the value of the current operations (i.e. the discounted value of the current net operating profits), plus the value of the future growth opportunities [Vg]. In the simplify approach that we use here, this second part is just the result of subtracting the first part, (i.e. the value of assets in place) from the market value of total capital [VT].
As you can see in the table below, [Va] plus [Vg] is equal to [VT] or 100%. The connection with the fundamental risk is simple: The greater the market value of the total capital of the corporation is composed of the value of the current operations [Va], the less significant is the value of the most uncertain part of the total value, i.e. the future growth opportunities [Vg]. For IBM, the market value of its total capital is lower than the value coming from the current operations, the most confident part of its value. It means that the investor who buys IBM gets the value of the assets in place (i.e. the value of current operations) at a bargain price and get the value of future growth opportunities for nothing.
For Accenture, Oracle and Cisco you need to put more reliance on the future, and the most unpredictable part of the estimation, to arrive at the current market value of total capital. These are normal situations. That applies to Hewlett-Packard due to its performance spreads that we have presented before.
Intrinsic Value, Value of Assets in Place, Value of Growth Opportunities
(Trailing 12 months)
First and foremost, invest or stay invested in IBM. This stock is a rock-solid choice for the very risk averse investor who is ready to wait the time it will take to right-size the company. It will pay off gradually over the next several years. Anyway, new investors do not even have to pay for the value of the growth opportunities.
Second, why not take the opportunity to diversify the information technology services part of your portfolio by investing in Oracle and Accenture when their market prices will have converged to their intrinsic values? The information technology services part of your global portfolio will let you sleep at night.