IBM's Hidden Source Of Value

| About: International Business (IBM)


IBM trades at a discount relative to its peers.

It is a Dividend Contender, having increased its dividend for nineteen consecutive years at a CAGR of 19%.

Its massive share repurchase program is boosting EPS.

This article is part of an ongoing series that highlights specific companies that are on sale. It helps me to document my thought processes when I add to my holdings or initiate new positions. Please provide your feedback in the comments section below.

International Business Machines (NYSE:IBM) is currently offering investors an opportunity to buy portions of the company at about $185/share. The stock had been steadily rising for most of 2014, but has recently pulled back since reaching its 52-week high and may now provide a good entry point. Right now, IBM is about nine percent off the 52-week high, hit a couple months ago at over $202 per ownership interest. Essentially, IBM has earned a whole quarter's worth of profit and repurchased three months' worth of shares, yet the price is quite a bit lower than it was before that happened. This few-week pullback provides long-term investors with a good opportunity to initiate a position.

International Business Machines has a business model that is simple and sustainable. It provides IT services and products to industries worldwide. In its 2013 annual report, it mentioned that income per diluted share actually grew 7% from 2012 to 2013, augmented by its share repurchase plan, which will be discussed below. IBM is able to increase its earnings at a rate that keeps up with inflation, passing along the devastating effects of inflation on to the consumer, not the owners.

Despite the growth, I believe that International Business Machines trades at a discount to its true valuation. IBM currently trades at under 12 times ttm earnings and under 9.5 times projected next year earnings. EPS is expected to grow 11% next year and about 9% annually for the next five years. IBM appears to be heading in the right direction as a company, and I am content to accumulate shares at this perceived discount.

Also, International Business Machines is a cannibal! IBM has been buying back its own stock at a pace that affects the bottom line. Just one year ago, four short quarters, there were over 1.113 billion shares outstanding of IBM. Today, there are about 1.035 billion diluted shares. In one year, International Business Machines has retired over seven percent of its outstanding share volume! The company has indicated on many occasions that returning cash to shareholders via share buybacks is an important goal for management. They are using their free cash flow to buy out other shareholders, which further adds to the gains of the remaining shareholders.

Let's take a look at IBM's earnings. Analysts are expecting a consensus EPS of $4.31 for the next quarterly earnings release, with the lowest estimate coming in at $4.20. For reference, IBM reported EPS of $3.91 for the same quarter last year and $2.54 for this most recent quarter (Q1 earnings reported April 16th). It appears that analysts are expecting some growth from IBM. IBM is buying back shares in a way that moves the EPS needle in a mighty way. Due to this, IBM wouldn't have to make more in total earnings to affect the bottom-line EPS. Even if profits stagnate, EPS will increase due to the share buyback. Even if EPS remains flat, you're still only paying twelve times earnings. That's less than the PE of many of its competitors. I believe that International Business Machines will have a positive surprise, and this is the catalyst that will cause IBM to reverse its recent downward trend and close substantially higher at the end of 2014.

Let's take a quick look at a few of IBM's competitors, Accenture (NYSE:ACN) and Xerox (NYSE:XRX). IBM has the lowest earnings valuation with a P/E of 12.5, compared to ACN's 20 and XRX's 13.5. Additionally, IBM's margins crush the competition, with gross margin coming in at almost 50%, an operating margin of 20%, and a profit margin of over 19%, potentially indicating an enduring economic moat. IBM's ROE of 98% also crushes ACN's 57% and XRX's 9%. Compared to its competitors, IBM seems to be undervalued at the present time. International Business Machines is the type of company that I want to own for the long haul, and this appears to be an opportune time to add to my position.

Turning to yield, International Business Machines also has a solid yield for such a large and growing company. You literally get paid to wait. IBM has a current yield of over 2.4%. IBM is a Dividend Contender, having raised its dividend for nineteen consecutive years. Its 10 year dividend growth rate is over 19%! Is this sustainable? Absolutely. Its payout ratio is only 21%, giving it ample room to increase its dividend. Additionally, IBM is sitting on $9.59 of cash per share. That's over eight quarters' worth of dividend payments! Its most recent dividend increase was for 16%. With these dividend growth rates, your yield-on-cost will be very high after a few years, especially if you are reinvesting your dividends. Its dividend growth rate of 19% is a much faster pace than inflation. That means that if you are relying upon dividend income to sustain you, you would not lose purchasing power over time. In fact, it would grow. IBM is a dividend king!

Despite its future growth and massive share buyback activity, the real attractive quality here is to buy a profitable company at twelve times earnings. Even if profits were to stagnate or regress from here, it's still trading at a low earnings multiple. This is a profitable company with solid free cash flow and high margins. I believe that IBM is a very healthy company. I welcome the opportunity to add to this position.

As always, this article represents my opinions at the time of writing. You should do your own due diligence before making any decisions. However, I believe that International Business Machines represents a quality company that is trading hands at a discount.

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.