The main thrust of this analysis is concentrated in three parts. The first two parts are based on free cash flow (current and historical) and the third is based on historical price action as a gauge of investor sentiment.
The three methods used in this analysis are:
1) Price to Owners Earnings (OE) = Current and future analysis
2) Cumulative Owners Earnings (COE) = Historical analysis of owners earnings
3) Statistical Indicator Analysis (SIA) = Historical price action
For those new to this analysis please see these links for an introduction: OE and COE, SIA , CapFlo.
The main goal of my analysis is first to determine a sell price. With that in mind, we attempt to buy the stock at half its sell price and then hold it for 5 years (provided that no macro- economic negative catalysts force us to sell). Due to the fact that we bought it at par, we can potentially achieve an average annualized return of 15% per year. This may enable us to double our money every 5 years. Occasionally we do find a stock that is not selling at par, but is actually selling at a discount. When this happens, gains are usually higher.
Analysis of International Business Machines (IBM)
Technology stocks are all the rage these days, so I thought it would be a good time to analyze the Patriarch of the Industry, IBM. The following is a table [click to enlarge] housing IBM’s Owners Earnings data from 1973-2011 (including estimates);
IBM’s closing price on December 23rd was $145.89 and its OE per share for 2009 came in at $11.47, which would give us a Price to OE (P/OE) of 12.71. I usually sell stocks that hit 30 times their P/OE, so at 12.71, using 2009 final results, IBM seems to have a long way to go before it becomes a sell on our P/OE scale. Since we are at year end and have 3 quarters of reported data in the books already, it is safe to use our 2010 estimate for IBM’s OE per share, which is estimated to be $12.60. Using that figure we then get $145.89/$12.60 = 11.57. At our sell indicator of 30 times P/OE, our sell price for IBM would be $378 a share. This may seem a little rich, but when you figure that IBM will pump out $15.62 Billion in Owner’s Earnings in 2010 and more than $50 billion in the next three years, it doesn’t seem that silly at all.
On the COE front IBM came in with the number of $104.37 and our sell price is usually 2.0 times COE or $208.74. Obviously IBM has ramped up their OE production, but they weren’t always a High OE producer as can be seen in the chart below:
In the last 10 years, 2000-2009, IBM generated 150% more OE than they did in the previous 27 years combined (1973-1999). How is this possible? Well the reason is that IBM’s management has gradually moved their business model away from hardware and focused instead on software and services.
Hardware is very capital intensive and really eats into a company’s cash flow. IBM’s management realized this and made some brilliant moves a few years back and sold off non-core divisions, such as their personal computer division (Think Pad) to Lenovo of China. At the same time they beefed up their services and software divisions, by using their strong free cash flow to make key acquisitions.
If one analyzes IBM using my theory on CapFlow, they will find clear proof that this change has been underway for some time now and is working wonderfully. From a qualitative point of view, it also shows that management is extremely capable as they are constantly looking to reduce capital spending whenever possible, but at the same time increase their cash flow.
Here is IBM’s CapFlow chart:
Back in the 1980’s IBM’s management was having some problems with their antiquated hardware centric business model and were spending more in capital expenditures then they were producing in Cash Flow. This was a serious problem and was not something that could be corrected overnight, but management has stepped up to the plate, made the necessary adjustments and slowly, year over year, reduced their CapFlow to the point where they are now at capital spending levels very similar to pure software companies like Microsoft (MSFT) or Oracle (ORCL). IBM is no longer the same company your father used to own and its turnaround is truly something amazing and one for the record books.
As far as SIA goes, our current SIA for IBM is $84.31, so it is trading currently at 1.72 times its SIA. I like to sell at 2.0, so from a strictly SIA point of view IBM has a sell price of $168.62.
The following is a chart of IBM’s SIA from 1976-today;
Again, IBM is a member of the DJIA and as we previously said, is the Patriarch of the tech industry, so it should usually always sell at a premium. But when using SIA, every once IN a while some very interesting opportunities show up, and the following that happened to IBM is no exception to the rule. At number 8155 (bottom horizontal axis of chart), which is actually November 20, 2008, IBM broke below its SIA of $70.29, coming in with a price of $69.02. The following day it shot up to $72.04 and the day after that, it went up to $76.86. We find it very interesting that the stock only dropped below its SIA once (and for only a day) since it last did so on October 14, 1992. Anyone buying the stock in 1992 would have seen it go from $15.47 to $120 over the next 8 years for a return on your investment of 675% and having bought the stock at $69.02 in 2008, would have resulted in a gain of 112% in just two years. So when an investor is able to buy at or below our SIA line, there is a very high probability that large gains can be made, when strong P/OE and COE are also added to the equation.
So for IBM we now have three separate sell prices;
1) P/OE = $378.00 (30 times 2010E OE per Share)
2) COE = $208.74 (2 times COE)
3) SIA = $168.62 (2 times SIA)
Total = $755.36/3 = $251.78 = Sell Price
Buy Price = $125.89
Conclusion = IBM is a Strong Hold
Disclosure: Long IBM, MSFT, ORCL
