The Bull Case For IBM: A Revision Of The DCF, A Look At ROIC

Aug.18.14 | About: International Business (IBM)

Summary

It is common knowledge that IBM has been facing many difficulties as a result of their transition to a very different business line.

As a result, many investors are wondering if IBM's managers are up to the task.

I take a look at IBM's ROIC, a measure of core operating profitability against invested capital to determine whether investors should trust in IBM's managers once again.

Back in April, I wrote an article analyzing IBM's recent performance. Since then, IBM has released its 10-Q for the second quarter. I have updated my DCF with the new data.

Discounted cash-flow analysis

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Source: SEC Filings, author's own estimates

As seen above, I have also updated the assumed growth rates given the headwinds that IBM faces in their corporate strategy transition. I have taken the average of the previous years and assumed a marginal improvement of 1% per year.

With that, IBM's revenues are projected to decrease to $93bn by 2019 before increasing once again. This is in line with the market expectation of the IT behemoth to face challenges in this difficult phase.

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As seen above, costs are expected to decrease in line with the assumed decline in revenue, remaining flat at 52.1% of sales. Gross profit is hence at 47.9% sales, decreasing from $46bn in 2015 to $44bn in 2019.

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Source: SEC Filings, author's own estimates

As seen above, operating expenses are expected to decrease in line with the assumed decline in revenue, remaining flat at 29% of sales or $27bn-$28bn in the next five years.

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Source: SEC Filings, author's own estimates

As seen above, net income is projected to decrease from $14.4bn to $13.9bn in the next five years. EBIT is projected to decrease from $18.6bn to $18bn in the next five years. EBITDA is projected to decrease from $24.1bn to $23.3bn in the next five years. EBIAT is projected to decrease from $14.7bn to $14.2bn in the next five years.

The above decreases are once again assumed purely due to the fact that it is no secret that IBM is facing hardships transitioning its business strategy.

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Source: SEC Filings, author's own estimates

As seen above, non-cash charges, such as depreciation, amortization, and stock-based compensation and so on, are projected to remain about flat at $5bn or 5.5% of sales in the following five years.

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Source: SEC Filings, author's own estimates

As seen above, changes to working capital are projected to remain steady at $1.3bn or 1.4% of sales in the next five years.

Taking into account the above, IBM's free cash flow is projected to remain flat at about $14bn-14.4bn in the following five years. Concluding the DCF analysis, I obtain a fair value of $192.11 for IBM, which is about its current trading price. Hence it is fair to say that my analysis is roughly in line with the market's expectation of IBM's performance in the near future.

ROIC analysis

However, everyone wants to know whether it is wise to invest in IBM at this current time. As I have mentioned above, IBM is undergoing a massive change in its business strategy. Most businesses when undergoing such change are not able to maintain their profitability, cash flow, and in turn, returns on invested capital. Suffice to say, changing such a large part of the business is a daunting task and most managers would not be able to maintain the company's overall cash flow generation.

Hence, in order to discover if IBM's managers are up to the task, as they have been in the past, I will proceed to analyse IBM's ROIC over the past years.

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Source: SEC Filings, author's own estimates

Returns on invested capital measures the company's core operating profitability post-tax (EBIAT), which is to say, its profits generated from core operations, against the investment ("invested capital") it makes in order to generate these profits.

As seen above, cash & cash equivalents, marketable securities, prepaid pension assets, goodwill and intangible assets are removed from invested capital calculation due to them either not being part of core operating assets or are due to acquisitions effects.

One might wonder why I am totally excluding cash & cash equivalents from the invested capital calculation. The reason is simple. Most of the time, companies do not require all of their cash to fund operations, most require less than 10%. Hence there is excess cash lying around on the company's books. I have removed them entirely from the calculation due to IBM's relative ease of raising cash from either its operations or from lenders.

From the above, we can see that IBM has been able to maintain its core operating profitability during its transition period in the past years, due to its ROIC being steady at about 20%.

The above conclusion tells us a lot about IBM's managers. With the tech giant undergoing such huge change, most managers would sacrifice on profitability and efficiency, thus reducing their ROIC, however, IBM has not. This tells us that this transition is one that is value-creating. Once again, it seems that IBM's managers are not disappointing us. Hence, I believe that although the future seems filled with obstacles, I am confident that IBM's managers will be able to navigate the company through these problems.

I don't see why you shouldn't.

As always, my analysis on Excel can be viewed here.

Disclosure: The author is long IBM. 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.