Buy IBM As A Late Christmas Present... With Reason

| About: International Business (IBM)

Summary

With IBM continually initiating buybacks, outstanding shares have fallen, while other statistics remain the same.

My DCF analysis shows IBM as undervalued.

Actual earnings move in tandem with the stock price, but other statistics also show important fundamental-to-price trends.

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After my article on Verizon (NYSE:VZ), I received the following reader request to repeat my analysis on International Business Machines (NYSE:IBM):

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I will write this article in the form of questions, answering them one by one. If you like this form of article, please let me know and I'll write more in the future. The main idea was to look at the outstanding questions about IBM and find statistical answers to them.

Is Free Cash Flow Falling?

I've never played IBM, either as an investor or a trader. So, naturally, before writing this article, I dug into the investor comments on this stock. The yield is nice, at about 3%, which is essentially equivalent to the yield of Altria Group (NYSE:MO) - a great stock, by the way. However, some investors are worried about the cash flow of the company. Thus, this was my first analysis on the stock:

While free cash flow (FCF) certainly has dipped in the last year, it is nowhere near low. The concern that IBM is wasting its cash and not appropriately distributing it to its shareholders is unfounded. The cash flow in 2015 is 99.29% of what it was in 2014, which was 20% higher than what it was in 2013. Cash flow is on the rise.

Yet, some shareholders, still worried about free cash flow, ask whether the dividend is still sustainable at the current cash flow levels.

Is the Dividend Sustainable?

Let us begin by looking at the dividend per share over the years. The dividend per share certainly has increased over the years:

The growth of the dividend has been faster and more stable than the growth of the stock. The dividend, on a steady incline, differs from the stock, which has traded up and down within the $50-200 range over the past ten years. Dividend investors should be happy, as even if the price of the stock (allowing you access to the dividend) is sometimes at a low, yet the dividend increases:

And it's not like the shares are being diluted to sustain this dividend. In fact, outstanding shares have fallen, meaning IBM has implemented buybacks. This is a common process with the company, which announced in October its intent to buy back $4 billion shares. In other words, each outstanding share of stock is becoming worth more, simply due to the lack of supply:

Of course, more important than the number of outstanding shares or the flat dividend is the yield, which is simply the dividend payout divided by the price of the stock. The yield has been on a steady rise since the relative low of 2012:

To see whether the company can continue its dividend payout, it is somewhat useful to see how its net income relates to the dividend. If net income is under the dividend, clearly we have a problem. Generally, investors will look at the percentage of net income dedicated to the dividend, and in IBM's case, we see no problem except for the recent decline in net income.

However, when plotted against net income, we do indeed see a problem in the last year. The dividend payout over the last year has increased as a percentage of the net income, from 24% to 35%. The previous years showed a steady incline, but we now see a sudden jump in this percentage:

Honestly, a more important ratio is the percentage of the free cash flow paid out as the dividend. Free cash flow is a much better metric of a company's ability to continually pay out a dividend to its investors. And IBM looks good, despite the recent net income decline:

For the past five years or so, the company has paid out only 40% of its free cash flow to investors. In my opinion, IBM is a value stock, making 40% rather low. I would like to see it rise to 60% or so. In any case, the dividend looks safe from an FCF perspective.

Is IBM Appropriately Valuated?

We know that the FCF has declined in the past year. And the growth rate has also suffered an intermittent decline. But overall, they are both on the rise; this contractive information has caused investors to ask whether IBM is overvalued or undervalued:

A discounted cash flow (DCF) analysis can best answer this question. In such an analysis, instead of running the "current date" figure, like many sites do, I look at the overall DCF valuation versus the stock price. This can tell us whether the analysis is actually useful.

I have coded a DCF analysis of IBM for the past 10 years to see how the stock price acts (or reacts) to the actual intrinsic valuation of the stock (as per free cash flow and other fundamentals). The result follows:

We can see that the DCF valuation has its rises and falls, but overall, is on a steady rise. The stock was undervalued until 2012, at which point it became fairly valued. Investor sentiment pushed the stock price down, keeping it below, although the current DCF valuation puts it at over $300 per share.

That is to say, IBM is actually undervalued as per its DCF valuation. However, due to its recent grow and FCF problems, the valuation has fallen a bit. Still, it is only 50% of its true value as per this valuation methodology.

Some investors might be skeptical. Indeed, had I run this analysis anytime before 2011, I would have made the same conclusion: IBM is 200% undervalued. I'm sure at that time, no investors would have believed me. Yet, in 2012, the stock reached its DCF valuation. I believe it is inevitable that the two lines cross again, whether it be the stock reaching its true valuation or the valuation falling to the stock value (i.e., investor sentiment is right about current company management; the fundamentals will continue to fall).

Does IBM Have Seasonality?

Many tech stocks have a seasonal trend in earnings. IBM is no exception. In fact, in recent memory, it is the stock with the most seasonality I've ever seen, with its best earnings coming in the fourth quarter:

With the best earnings reports clearly being those of Q4, and the company's Q4 earnings report coming out January 19, this makes now a more important time than ever for investors in the stock. In other words, if you are bullish on IBM, now is the time to be bullish!

Earnings are important, and for IBM, with the EPS being closely tied to the actual price of the stock:

Conclusion

Overall, I ran a completely objective analysis on IBM. I'm not invested in the stock, nor do I plan to invest. Yet, my barrage of analyses shows it only in a good light (with the exceptions of the recent falls in FCF and growth).

I suggest anyone interested in IBM to invest before the company's Q4 earnings report is released. That is, while we have had a bad week due to China, Iran, and Saudi Arabia - this should not scare potential investors or current investors wishing to invest more in IBM. Now is the time for the company!

Options Plays

Because I am a lover of options, I will be offering options plays on all my recommendations. Here are some for IBM:

Call spreads for upside investors:

Buy Feb16 140 Call

Sell Feb16 150 Call

Straddles to speculate before earnings (buy this week):

Buy Feb 16 140 Call

Buy Feb 16 140 Put

Covered calls for investors afraid of sideways trends:

Buy 100 shares of IBM

Sell 1 Jan 16 132 Call

Request a Statistical Study

If you would like for me to run a statistical study on a specific aspect of a specific stock, commodity, or market, just request so in the comments section below. Alternatively, send me a message or email.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.