Avoid IBM; Buy HP, RIM Instead

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Includes: BBRY, GOOG, HPQ, IBM
by: Cris Frangold

Contrary to management enthusiasm, acquisitions are typically bad for the shareholders of the acquiring firm and good for shareholders of the target firm. Recent news featured preliminarily interest by IBM (NYSE:IBM) for Research In Motion (RIMM)'s enterprise-services unit. This business unit operates Research In Motion's secure server network which is currently used to run BlackBerry smartphones. Though the chances of this acquisition taking place at this time are slim, investors should shy away from IBM in favor of target firms and stocks whose acquisition damage is already priced in their shares.

Deal Interest

RIM's secure server network is attractive for IBM because Research In Motion's fast and safe email system is utilized by many large businesses. The profit Research In Motion made from this service last year was $4.1 billion, and when valued, this service makes up the lion share of RIM's worth in the eyes of investors. Although Research In Motion has high hopes for the BlackBerry 10, which will be the product of efforts to reinvents the BlackBerry, developers have already hit a few design hitches. Additionally, many app developers only create software for the more popular phones; BlackBerry will need to get back on app designers' radar in order to compete. Should this new model fail, offers to sell its network may be very welcome; Research In Motion already has downsized the number of employees by two-thirds, is closing manufacturing sites, and fell to 4.8% in the international smartphone market in the second quarter.

Research In Motion is planning to introduce the BlackBerry 10 in early 2013, and so much of BlackBerry's appeal in today's market lies in its network. CEO Thorsten Heins is not ready to throw in the towel just yet, though. He has hired JPMorgan Chase (NYSE:JPM) and RCB Capital Markets to help determine strategy. Heins stated that Research In Motion would be more open to a partnership or to licensing its network rather than selling it. As it stands now, this unit of Research In Motion is worth between $1.5 billion to $2.5 billion depending in part on whether the technology is modified to be more compatible with non-BlackBerry systems.

The chances of this acquisition taking place at this time are slim because IBM is not interested in the phones themselves. After all, the once very successful BlackBerry has suffered losses with the debut of Apple's (NASDAQ:AAPL) iPhone and Google's (NASDAQ:GOOG) Android.

Investor Opportunity

Trading near $200, IBM shares are valued at 14.44 price-to-earnings ratio and a 2.15 price-to-sales ratio. This price level is near its $210 per share high, and clearly does not include negative sentiment associated with acquisitions. In the event that this acquisition or similar acquisitions are consummated by IBM, this share price could go down. This is an unattractive proposition because there was no drop in share price in reaction to the acquisition interest. Thus, investors should not expect any upside if IBM declines on the acquisition.

Instead, investors should try to find acquiring companies which are already priced cheaply, instead of hoping the market will not wake up to the damage acquisitions tend to cause firms. This is simple advice: wait until the market reacts to bad news before you buy. One technology company which currently trades at low valuations based on past acquisitions is Hewlett-Packard (NYSE:HPQ). It trades more cheaply than Google and IBM which takeover smaller companies routinely:

Ticker

Company

P/E

P/S

P/B

P/FCF

 

Google

19.03

4.86

3.24

16.39

 

Hewlett-Packard

7.64

0.31

0.94

10.18

 

IBM

14.49

2.15

11.13

18.81

Click to enlarge

The price-to-earnings ratios, price-to-sales ratios, and price-to-free cash flows ratios point to Hewlett-Packard being a better value. Though the price-to-book ratio does not confirm a tech company as being expensive since intangible assets are often off the balance sheet, the price-to-book ratio does confirm cheapness: Hewlett-Packard is cheap because it is trading below the book value of its assets, ignoring intangible assets altogether.

What about Research In Motion as an investment? Its share prices have already reacted very positively to the news of acquisition interest. The shares are trading near $8, which is higher than $7 levels the share traded for prior to this news. It appears that RIMM shares have already priced in optimism from this potential asset sale. Thus, if this deal goes through, investors do not have much upside to capture from this event. On the other hand, if IBM stalls or turns down this deal, it is possible that RIMM share prices could descend back to $7.

But on a fundamental level, Research In Motion is a value buy in the basis of the sum of the firm's parts. Its working capital is worth $3.7 billion, and its enterprise-services units could fetch at least $1.5 billion. The firm has $0.2 billion in long-term liabilities, which brings the sum of these parts to $5 billion. The market capitalization of RIMM stock is about $4.2 billion. Thus, investors get to buy net assets for a 4% discount and they also get the prospects of a turnaround for free.

Conclusion

In light of market movements, IBM's potential purchase of assets from Research In Motion makes IBM unattractive at current price levels. Investors would be better served buying shares of Hewlett-Packard because its share price reflects the challenges presented by past acquisitions. Investors should also consider Research In Motion as an attractive 'sum of parts' value play.

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