One inherent problem in valuing tech firms concerns the lack of visibility in growth projections. To mitigate risk, investors should look for tech firms with strong free cash flow generation and future catalysts to unlock value. Based on my review of the fundamentals and multiples, I find strong upside for Xerox (XRX) and Microsoft (MSFT), but weak upside form IBM (IBM).
From a multiples perspective, IBM is the only of the three to trade above its 5-year average PE ratio. It trades at a respective 14.8x and 11.8x past and forward earnings while Xerox and Microsoft trade at a respective 9x and 11x past earnings. Xerox and Microsoft are only 46% and 78% their 5-year average PE ratio. In addition to lagging by this metric, IBM also has the lowest dividend yield at 1.6% and the lowest free cash flow yield at 5.4%. With Xerox leading in free cash flow yield at 10.8%, I find that it would be meaningfully accretive to IBM.
At the fourth quarter earnings call, IBM's management noted solid momentum moving into 2012:
"In the fourth quarter, we grew revenue, expanded growth, pretax and net margins and delivered operating earnings per share of $4.71, up 11% year-to-year. For the full year, we delivered revenue of almost $107 billion, which was up 7%, operating pretax income of $21.6 billion, up 9%, and operating EPS of $13.44, up 15%. Our 2011 results put us well on track to our 2015 roadmap objective.
Looking at the fourth quarter by segment, we continued to build our momentum in software, our performance reflecting both strong demand for our offerings and leadership sales execution. Our software revenue was up 9%, driven by aggressive growth in our focus areas like Smarter Commerce, business analytics and storage solutions. Our software profit was up 12%".
The firm remains focused on mergers and acquisitions to increase scale. With services becoming increasingly competitive, IBM should acquire Xerox and boost the target's top-line momentum. IBM is known for its strong visibility in Xerox and has a flexible balance sheet that allows takeover activity. Management is further committed to returning profit to shareholders through buyback activity, but could benefit from bolt-on streams of free cash flow.
Consensus estimates for IBM's EPS forecast that it will grow by 11% to $14.92 in 2012 and then by 10.1% and 9.5% in the following two years. Assuming a multiple of 13.5x and a conservative 2013 EPS of $16.02, the rough intrinsic value of the stock is $216.27, implying just 12.3% upside.
Xerox has been working on improving its financial shape and has established a leading presence in business processes through the acquisition of ACS. With that said, earnings remain uncertain given competitive pressure and input inflation. No matter, if the firm trades at just 11x and 2013 EPS turns out to be $1.18, the stock would surge by 62.9%.
Moving over to Microsoft, we find a company that has had a solid start to 2012. Revenue growth was experienced in all segments - even in Europe. The firm is just starting to bring its services together under a cloud platform and Office 365 represents a major catalyst in this endeavor. Meanwhile, the partnership with Nokia (NOK) in Windows Phone has shown solid progress.
Consensus estimates for Microsoft's EPS forecast that it will decline by 0.4% to $2.68 in 2012 and then grow by 11.6% and 11% in the following two years. Assuming a multiple of 13x and a conservative 2013 EPS of $2.95, the rough intrinsic value of the stock is $38.35, implying 26.4% upside.