IBM Inc. (NYSE:IBM) was the intrepid pioneer of the industry that created the market for utilizing computers for business purposes from the 1960s to the early 1980s. None could have envisaged then that within a decade, this mighty muscle would be fighting for relevancy. The early 1990s were especially tough on IBM:
- The company was reporting large losses.
- The share price hovered around $12, a level it first breached twenty years ago.
- In spite of its lifetime employment policy, IBM had a major layoff in 1991 - close to 50,000 or about 12% of the company.
- IBM’s board forced the resignation of its CEO John F. Akers in 1993.
Mainframe machines and software, a decelerating business, accounted for 90% of IBM’s business. The advent of client-server computing had many analysts predicting the death of mainframes – the fact mainframe software generally ran only on specific hardware platforms and the perception of high pricing resulted in corporate America attempting to shift their business to a client-server computing model. When outsider Louis V. Gerstner, took over the reins in April 1993, the idea to split IBM into “Baby Blues” was gaining momentum. But what ensued in the next decade will be remembered as one of the biggest turnaround stories of corporate America. The key events instrumental for the first phase of the transformation were:
- Gerstner’s decision to axe the plan to divide IBM: His experience as an IBM customer at RJR and American Express (NYSE:AXP) helped him realize mainframes were indispensible as running large business processes on PCs is next to impossible. As an outsider, he was aware of every industry’s need for an integrator, and in the tech industry IBM was poised to take that role.
- Stabilizing IBM: This was achieved through a combination of strategies – non-core businesses were sold to raise cash and massive layoffs helped control costs. The employee headcount dropped to around 225,000 by 1995 from the 400,000 range in the late 1980s.
- Shifting gears to focus on high-margin businesses: Low margin units like IBM Network, Hard Drives, etc were shelved in favor of high-margin growth opportunities such as software and services. The decision to provide integration of the technologies per the client’s requirement in lieu of solutions based solely on IBM technology was pivotal to the success of IBM Global Services. Several large acquisitions in middleware including Lotus, WebSphere, and Tivoi paved the way for IBM developing a large cross-platform software business that competed successfully with heavy weights such as Microsoft (NASDAQ:MSFT), Oracle (NASDAQ:ORCL), and Hewlett Packard (NYSE:HPQ).
- Recapturing its reputation: The IBM ThinkPad laptop computer introduced in 1992 and the chess match between IBM’s Deep Blue computer and reigning chess champion Gary Kasparov in 1997 rank high in that list. ThinkPad’s unique design and certain distinctive features such as a TrackPoint device in the middle of the keyboard garnered quite a following among the tech elites. Deep Blue’s victory in the chess match made news across the globe as it was the first victory ever for a computer over a reigning world champion.
In 2002, Louis Gerstner retired and long-time insider Samuel J. Palmisano took over the controls from him. By that time, IBM’s product mix was 40% services, 25% software, and 35% hardware and financing. Gross Profit Margins were at 36.6% and pre-tax income margin at 7.2%. Palmisano’s philosophy for the first 5-years paralleled that of Gerstner viz., remixing IBM’s business to high-margin areas and reducing costs. By 2007, the product mix had shifted further to software and services – 40% software, 37% services, and 23% hardware and financing. Margins showed marked improvement with the gross margin at 41.9% and pre-tax income margin at 14.6%. That resulted in earnings per share almost tripling from $2.43 in 2002 to $6.06 in 2006. The projections for 2010 called for IBM’s software profit to approach 50% of the overall profit. The 2010 figures show software profit coming in at 44% of the total profit, slightly below projection. The company still managed to almost double earnings per share to $11.52 with gross profit margin at 46.1%. For 2011, the company is on track to earn around $12.95 net earnings per share. IBM launched several initiatives to sustain growth including Cloud and Smarter Computing, Business Analytics and Optimization, and Smarter Planet. Some of these initiatives were a consequence of acquisitions. The chief acquisitions and divestitures from the period include:
- Dec-’02: Sale of IBM’s Hard Disk Drive unit to Hitachi (HIT) Global Storage Technologies – ~$2 billion,
- Dec- ’04: Sale of IBM Personal Systems Group to Lenovo Group (OTCPK:LNVGY) – ~ $8 billion,
- Oct ’06: Acquisition of FileNet Corporation (content management software) – ~$1.6 billion,
- Oct ’06: Acquisition of Internet Security Systems (information security software) – ~$1.3 billion,
- Jan ’08: Acquisition of Cognos (business intelligence software) – ~ $5 billion,
- July ’09: Acquisition of SPSS Inc (statistical analysis software) – ~$1.2 billion,
- Sep ’10: Acquisition of Netezza (data warehousing and analytics appliance) – ~$1.7 billion.
IBM’s roadmap calls for operating earnings to be at least $20 by 2015, which assumes the average growth in the coming four years to be at the minimum 8%. This is a cautious projection, given IBM achieved earnings growth of 13.49% in the last six years. The 3Q 2011 report and conference call gives several hints on the status of IBM’s business:
- IBM showed an impressive 13% revenue growth in the Growth Markets Unit (GMU), which on a comparative basis is an accelerating trend – the revenue in GMU grew 12 points faster compared to growth markets. The differential was 8 points in 2008 and 2009, and 10 points in 2010.
- New growth initiatives are performing splendidly with Smarter Planet up 50% YTD, Business Analytics up 20% YTD, and Cloud Revenue doubling in the same period. The growth in these areas is well ahead of the 11-12% CAGR projected in the 2015 roadmap.
- Even though the company managed to grow net income by 7% as their gross profit margin expanded by 1.2 points to 46.5%, the overall revenue growth was just 3%. The quarter showed revenue growth of just 1% in the Systems and Technology Group (STG) and revenue decreased by 2% in the Financing Segment. The deceleration in revenue in the Finance Segment is a tad concerning as the segment showed good growth in previous quarters.
Overall, the business is performing very well compared with the 2015 roadmap projections. The risk to IBM exceeding these projections by a handsome margin is a global slowdown that could result in the delay and/or cancellation of projects.
Below is a look at Fair Value Estimates based on the latest earnings report (click for an understanding of the formulas used in the spreadsheet):
(Click chart to expand)
- Trailing 12-month EPS figure of $12.95 is from the GAAP earnings-per-share from the last four quarters.
- The current growth rate of 12.40% was derived by comparing the GAAP earnings from the last four quarters to the prior four quarters ($11.52), and getting the actual growth achieved.
- The 5-year and the 7-to-10 year earnings growth rate projections were estimated at 7% and 4% respectively – sizable discounts to what the company achieved looking backward and a slight discount to the company’s own growth projection laid down in the 2015 roadmap.
- The long-term growth rate is taken as 2% which is historically the average growth rate for USA as a whole.
The Fair Value Estimates using different models are described below:
- The PEG Model shows a Fair Value Estimate of $202.28, which is slightly higher than the current stock price. For a mature company like IBM that pays a good dividend the ratio is a fairly decent measure.
- The Benjamin Graham Model gives a Fair Value Estimate of $235.63. The major variable is the 7-to-10 year projected earnings growth rate, which was assumed to be 4%. IBM showed outstanding double-digit growth rate in the last 10 years, but it is unrealistic to assume that kind of growth to continue unabated for the next 10 years. Varying the 7-10 year growth rate number between 2% and 10% will give Fair Value Estimates between $178.51 and $407 using that model.
- The DCF Based Model gives a Fair Value Estimate of $323.58. The major variable with this estimate is the 5-year projected earnings growth rate, which was assumed to be 15%. Varying that number between 4% and 12% will give Fair Value Estimates between $284.40 and $398.88.
- The Dividend Discount Model gives a Fair Value Estimate of $176.47, which is below the current market price. The major variable with this model is the long-term dividend growth rate. IBM has grown its dividend at a very fast rate (20%) in the last few years. We applied a very conservative number of 6% for this rate. Varying that number between 5% and 7% will give Fair Value Estimates between $111.11 and $428.57.
Overall, the Fair Value Estimates shows a modest undervaluation of IBM shares in the market.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.