The electronics industry is by and large a risky industry, full of price erosion and development dead ends. The tablet craze has driven prices down to $199 for Google's (GOOG) latest Nexus tablet, along with Amazon's (AMZN) Kindle Fire tablet. There is an overall perception that certain consumer electronics, like smartphones and tablets, are becoming commoditized as manufacturers catch up with the latest and greatest from the leading brands.
Today, the challenge for any tech company is to transcend this fierce competition, and IBM (IBM) is doing just that. The new company is focusing on software and logistical solutions for its enterprise clients: Oracle (ORCL) considers IBM its major competitor in this market. But IBM has more to offer than just database solutions -- it claims to be paving the way for innovation in computing generally. With this broader vision of its business that lessens its exposure to any one market, IBM is a buy at $195.
IBM is competitively valued with shares trading at 13 times forward earnings, which is near the S&P IT Index average of 12.9. Oracle's shares are trading at 11.2 forward earnings. While this might make IBM seem more expensive than Oracle, the cash flow statement tells a different story. IBM's price/cash flow multiple is at around 10.8, whereas Oracle's is around 11.2. Additionally, IBM's price/sales ratio of 2.1 is below Oracle's multiple of 3.9. In all, the valuation picture for IBM is inconclusive.
That said, IBM's cash flow per share has been steadily increasing over the past decade, more than doubling to $17 per share in 2011 from $8 in 2005.
IBM is ready to usher in what it is calling the "third generation" of computing. This generation will involve the advent of cognitive computing, in which computer software running on advanced hardware will begin to "learn" new things like natural language and user inclinations. This, says Bernard Meyerson, vice-president for Innovation at IBM, involves a holistic approach to computing. Chip size is unlikely to dip far below 7 nanometers, according to Meyerson, so "if all you do is disk drives, or all you do is chips, or all you do is memory, you are dead pretty soon." These components, by themselves, will eventually hit a technological limit. In order for IBM to compete with devices like Apple's (AAPL) iPhone that runs Siri -- a piece of software that intelligently responds to user's requests -- it needs to enact this vision. Otherwise, IBM will lose market share to companies that are willing to develop such software for enterprise applications.
The company is taking measures to ensure that it is ready for this future. IBM's research budget for 2011 was $6.3 billion, up from $6.0 billion in 2010. This outdoes Oracle, which spent $4.5 billion on research in 2011 and $3.3 billion in 2010. While Oracle has been engaged in several acquisitions over the past two years -- most notably that of Sun Microsystems, which cost the company $7.4 billion. While acquisitions like this are positioning Oracle for profitability, it has yet to give it the momentum that IBM has in research and development. The money spent in this area seems to be paying off as IBM's operating margin increased to 19% in 2011 from 18.2% in 2010. Furthermore, despite the perceived sluggishness in the company's revenue, management upped earnings guidance this year to $15.00 per share, and the Street's outlook for next year's earnings is upwards of $16.20 per share.
Additionally, IBM recently extended its agreement with Lawrence Livermore National Laboratory to develop high-performance computers. This supercomputing facility is trying to harvest computing power to solve problems as diverse as national security, energy efficiency, and environmental problems. This will come as IBM gleans insights about how to deliver this high-performance computer to a global marketplace.
Market Strength and Investment Value
The company's strongest market hold is on logistical software linking business clients with various forms of hardware -- an amorphous market of "middleware" software. The total revenue from this stretch of its business totaled $6.3 billion in 2011, up from $5.5 billion in 2010. This includes Lotus, a business collaboration platform, and Websphere software, which functions like logistical "network glue" for businesses.
IBM invested $15 billion in share repurchases in 2011, which is a strong indication of the company's commitment to shareholder value. The company has also upped its dividend over the years, which will be about $3.30 for 2012, up from $2.90 in 2011 and $1.95 in 2010. The approximate dividend yield for IBM shares in 2012 will be 1.7%, which impressively overshadows the IT market average of 0.90%. In industries where fierce competition and price erosion are considerable risks, I like to see aggressive dividend distribution and share repurchasing.
IBM's overall return on equity at 74% is much higher than the IT sector average of 21%, indicating that IBM has a proven record of large returns for its shareholders. The company's shares are an attractive 12-month investment, with a relatively reliable share price target of over $220. The long-term prospects for IBM, however, are particularly appealing. The diversity of its business helps to insulate it against device crazes and other come-and-go market tendencies. Along with its attractive dividends and stock buybacks, IBM is an excellent overweight holding for any portfolio, representing the best the IT sector has to offer.