By Nawazish Mirza
International Business Machines Corporation (IBM) is an attractive stock with a P/E ratio of 13.78 backed by strong fundamentals based on strategic business positioning, diversified ventures, hefty revenues, mounting margins, and impressive free cash flows. In 2011, IBM achieved its all-time high operating income of $21.6 billion, with 44 percent contribution from the software segment, followed by 41 percent and 16 percent by the services and hardware segments, respectively.
This clearly indicates the management vision to position IBM with substantial profits from its hardware segment. Despite its previous hardware emphasis, with changes in profit dynamics in the IT sector, IBM has strategically moved towards the cash-rich software segment, with a target contribution of 50 percent in operating income by 2015.
Furthermore, continuous increases in revenues from emerging markets is an encouraging factor for IBM, since the future of the IT sector is highly dependent on the potential from emerging markets of China, India, and other Asia-Pacific markets. Based on this product and geographic mix, the operating EPS is expected to follow a compounded annual growth rate of 11 percent, reaching about $20 per share by 2015.
The IT sector in general has been surrounded by uncertainty due to recessionary pressures in North America and Western Europe. Market dynamics have changed with the rapid success of smartphones and portable gadgets that have not only revolutionized the industry but also posed serious challenges to the existing companies in the PC and software markets. Hewlett-Packard Co. (HPQ) experienced a 12 percent reduction in shipments, while Dell Inc. (DELL) witnessed a decline of 11.5 percent.
Given this scenario, we expect IBM's hardware side to struggle to maintain a good profit mix. The core of IBM lies in its business analytics and cloud services that are expected to contribute substantially even in an otherwise challenging corporate IT scene. It is also remarkable that IBM has created its space in these areas, especially in the presence of Apple Inc. (AAPL) and Google Inc. (GOOG). Among software companies, IBM leads the stage with a return-on-investment of 73.7 percent and an annual dividend yield of 1.80 percent, compared to Oracle Corporation's (ORCL) return-on-investment of 23.6 percent and dividend yield of 0.8 percent.
Microsoft Corporation (MSFT) is also following IBM with a modest return-on-investment of 38 percent and attractive dividend yield of 2.7 percent. The advantage IBM holds over its peers is its diversified product mix and strong presence in emerging markets that are expected to fuel the growth of the future IT industry. The company's growth potential is also indicated by its price-to-book ratio of 10.3, compared to 3.6 for Microsoft and 3.3 for Oracle.
IBM is an attractive stock with very low market risk, evident from a significantly low beta of 0.65. Primarily, this indicates that IBM is not highly vulnerable to market turbulence. Even if the uncertain economic conditions result in some profitability issues, we feel that IBM has an opportunity set that is unmatched by its peers and, given its effective management, we are confident that IBM can sail with ease through these short-term unfriendly waters.
IBM has hefty operating cash flows of $20.3 billion, and historically, investors have been compensated handsomely via share repurchase programs and dividend payouts. Therefore, a technology company with stable financials, attractive future prospects, management with a proven track record, financial and technological flexibility, and strong geographic presence is a recommended buy. At present, IBM is trading at $184.7 with a P/E ratio of 13.78. We expect a 16% upside to current price with a target price of $214 and a forward P/E of 11.