Legendary value investor Warren Buffett may be hot about IBM (IBM), but in my view, the business service provider is nothing more than a stable premium bank account. It serves the point of storing cash and has attractively grown the premium. Yet, like most low-beta (ie. low risk) stocks, the upside is fairly low. By contrast, Xerox (XRX) and Hewlett-Packard (HPQ), which are respectively known for printing and computer hardware, provide business process outsourcing (ie. BPO) and are significantly undervalued. Unlike IBM, they lack the brand name that they once had - admittedly due to operational challenges and poor managerial decisions - and have become significantly discounted as a result.
Dubbed a "value trap", HP is actually a free cash flow machine. The $37.4B company generated $8.1B in free cash flow last year. If it were a "value trap", free cash flow would be floundering; yet it has been improving. In 2010, the company generated only $7.8B in free cash flow. Yes, free cash flow was $11.6B in 2008, but the point is that the company generates significant income to relative market cap, and it will stay that way into the foreseeable future (i.e. certainly within the next three to five years.)
On an earnings basis, HP is also overly cheap. It trades at a respective 7.4x and 4.3x past and forward earnings, as well as ~10% under book value. The company has also yet to cut dividend distributions and has become particularly generous without the 2.8% yield, which was introduced more than a year back and, mind you, is nearly 100 bps higher than what IBM currently offers.
Although the Street rates the stock closer to a "sell" than a "buy" according to FINVIZ.com, recent price targets suggest a significant discount to intrinsic value. Recent equity reports by Mizuho, Argus, and Barclays have given the company a price target of $25 - $30, which spans an upside potential of 32% - 58%.
Like HP, Xerox has lost much of its shareholder value over the recent past. It fell 63.5% from five years ago and is much closer to its 52-week low than its 52-week high. But the foundation of something that is undervalued still remains. At a respective 8.1x and 6x past and forward multiples, Xerox is trading well below the S&P 500's 15.4x multiple as well as the company's historical 19.1x multiple. It too offers a dividend yield that is higher than IBM's at 2.3% in addition to greater upside, by my estimates.
More importantly, Xerox's PEG ratio stands at only 0.57 right now, which indicates that future growth is not properly being taken into account. Over the past 5 years, earnings have fallen annually by 5.9% and 14.1% annual growth is expected into the next 5 years. This sudden change may be too much for the market to grasp right now, but it is what the consensus is. A similar case is responsible for why the market at large is undervalued despite a historically-high Shiller PE multiple.
So, Xerox is not as "broken" as the bears would have you believe. 5 years into the future is hard to predict, so let's consider the near-term. In fact, 2013 EPS of $1.21 should conservatively be worth between $10.89 (at a 9x multiple) and $18.15 (at a 15x multiple) in future terms. Discounting backwards by a rate of 10% yields a fair price target between $9 and $15; discounting backwards by an aggressive rate of 12% yields a bearish price target between $8.68 and $14.47. That means, at an absolute low, the company has a ~20% margin of safety. At an absolute high, the company has a 106% margin of safety. Put differently, the company is much more skewed towards reward.
By contrast, IBM is all about safety. It has a beta of 0.7 versus 1.6 for Xerox and 1.1. It should also thus be no surprise to value investor Buffett that his company trades at correspondingly high multiples. Actually, much higher multiples. IBM is valued at a respective 13.9x and 11.2x past and forward earnings. And, unlike Xerox, it has a PEG ratio of 1.3, which indicates that growth has been more reasonably factored into the stock price.
Love on the Street also isn't much greater for the large diversified tech service provider. It is rated only a "buy" according to data from FINVIZ.com. 2013 EPS is expected to be $16.60 in 2013. Discounting backwards by a generous 8% rate at a 14x multiple yields a price target of $199.25 for a nominal margin of safety. Of course, this is only likely to happen if IBM generates 13.4% EPS growth this year, which is not something to be sure of.
Over the past 5 years, IBM grew EPS annually by 16.6% and 561 bps less is expected over the next 5. Thus, I believe that growth expectations for IBM are overly bearish. Still, if the company grows at a 16.6% rate over the next 5 years, its future stock value would be $394.65 at a 15x multiple. An 8% discount rate would place the price target at $268.59 for around a 45% margin of safety. This figure makes aggressive assumptions both in terms of a low discount rate, a high multiple, and growth projections, and it still isn't even more optimistic than my conservative cases for HP and Xerox. Investors are thus encouraged to aggressively buy shares in the last two battered stocks. Buffett should have done the same if he was looking for diversification in the BPO space.
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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.