Is IBM Grossly Undervalued?

Aug.11.14 | About: International Business (IBM)

Summary

We focus on IBM’s strengths and weaknesses in this article.

Specifically, we look at its profitability, financial gearing, growth potential and income prospects.

We also compare its valuation to a GICS sub-industry peer to ascertain whether it offers good value for money right now.

This article focuses on one of America's technology stalwarts, IBM (NYSE:IBM), and discusses the company's strengths and weaknesses. It also compares IBM to Xerox (NYSE:XRX) and discovers that there could be a relative mispricing between the two companies. We decided to compare IBM to Xerox because they both sit in the same GICS sector of information technology, as well as the same GICS sub-industry of IT consulting and services. Clearly, the two companies are of very different sizes, with IBM having a market cap of $185 billion and Xerox having a market cap of $15 billion. However, we appreciate that many investors allocate their capital based on GICS sectors and GICS sub-industries, so we feel that the comparison should be useful and very worthwhile.

Tremendous profitability

The standout strength of IBM is its profitability. Indeed, last year it delivered a hugely impressive return on equity of 94.6%, while return on assets was also impressive, although to a lesser extent at 10.7%. Of course, IBM's return on equity is so high partly because it is hugely profitable, but also because it runs a significant amount of financial gearing. Indeed, the company's debt to equity ratio currently stands at a whopping 265%, which gives a substantial turbo boost to return on equity.

However, the strength of the return on asset number shows that it's not all down to a capital structure that relies much more on debt than equity. Indeed, we're impressed with how efficiently IBM utilizes its asset base and, moreover, with interest cover being 49.6 last year, we're comfortable that IBM won't see its bottom line hit too hard by interest rate increases.

Meanwhile, Xerox also scores reasonably well in terms of profitability. Since it runs far lower financial leverage levels, with it having a debt to equity ratio of just 60%, its return on equity figure is less impressive than that of IBM at 9.4%, while its return on assets number is again lower at 3.5%. We feel that, while these numbers are suppressed by lower debt levels versus IBM, IBM is by far the more profitable company of the two and more efficiently utilizes its balance sheet and asset base.

Growth Potential

It's a similar story when it comes to growth potential, with IBM offering investors higher EPS growth rates in 2015. Indeed, IBM is forecast to increase its bottom line by 10.8% in 2015, while Xerox's 8.1%, while still impressive, is still only enough for second place. Moreover, we feel that IBM could become a far more attractive income play over the medium term, due in part to its impressive growth prospects. For instance, its payout ratio is just 25%, while it yields a relatively attractive 2.4% (forward yield). This shows that, while IBM is right to reinvest large amounts of profit, as a mature company it could afford to be more generous with regard to its payout ratio. This, combined with strong earnings growth rates, means that IBM could, in time, become a strong income play and its shares could become more attractive as a result.

The same is true of Xerox, although to a lesser extent. Its payout ratio is only slightly higher than that of IBM at 26%, while its forward yield is lower at 2%. In addition, while growth potential is fairly strong, it isn't quite as impressive as for IBM. So, while Xerox could also become a far more attractive income play over the medium term, we feel that IBM has more potential in this space.

Valuation

Despite its strong growth prospects, income potential and high levels of profitability, IBM looks cheap at current price levels. For example, its forward P/E is just 9.4, which is 42% below the S&P 500's forward P/E of 16.2 and 13.8% lower than Xerox's (already low) forward P/E of 10.9. Indeed, IBM also looks like a great value on other ratios, with its PEG ratio being just 1.18 (versus 1.93 for Xerox) and its EV/EBITDA ratio, although higher than that of Xerox, still being attractive at 8.8 (versus 8.4 for Xerox). Despite a slightly higher EV/EBITDA ratio, we think that IBM is undervalued relative to its sub-industry peer right now and, as such, it could outperform Xerox going forward.

Conclusion

We're hugely impressed with IBM's profitability, with the company having a sky-high return on equity that shows it is delivering very strong returns for its shareholders. In addition, it has a return on assets ratio that provides evidence of just how efficiently it is using its asset base. Indeed, while returns are aided by high debt levels, we're not concerned by this, since interest cover is more than adequate and, moreover, IBM would still generate hugely impressive returns for shareholders even if it ran only moderate levels of financial leverage.

In addition, IBM has the potential to become a strong income play via an increased dividend payout ratio. It also has impressive bottom line growth prospects, as shown through EPS growth forecasts of 10.8% for 2015. Sure, Xerox also performs well on this front, with it having similar scope to increase dividends, as well as impressive growth prospects, too. However, as with profitability, its performance is a definite second place when compared to the might of IBM.

Despite this, IBM trades at very low valuations in terms of its forward P/E, PEG and EV/EBITDA ratios. In fact, two of the three (forward P/E and PEG) are lower than those for Xerox, while the EV/EBITDA ratios of the two companies are broadly similar. As a result, we feel that IBM could outperform its sub-industry peer going forward, as the market reacts to what appears to be a mispricing and bids up the share price of IBM going forward.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.