This article will focus on business analysis of IBM with a small portion of security analysis. Security analysis doesn't provide much value without business analysis.
1. Business Characteristics and Basic Facts
IBM has the four main segments of business: Global Technology Services, Global Business Service, Software, and System and Technology. Based on the 10K Form 2014, their total revenue is $92.7B and segment revenue distribution is as follows.
Segment | Revenue | Gross Margin | Percent of Total Revenue |
Global Technology Services | $37.1B | 38.3% | 40% |
Global Business Services | $17.8B | 30.8% | 19.2% |
Software | $25B | 88.6% | 27% |
System and Technology | $10B | 39.5% | 10.8% |
Other | $2B | 49.4% | 3% |
During the past several years, IBM's revenue and profits started to decrease. To reverse that situation IBM was transforming its business to catch up with the trend of the new technology - Cloud, Big Data Analytics, and Mobile. It divested some of its products and services that have low business values (low margin, capital intensive, decreasing market demands, etc.). In the meanwhile, it invests heavily in data centers for cloud computing, big data, and mobile computing. In this process its sales and revenues were affected adversely and that was not well accepted by the general financial community. Its stock price dropped for a high point of $210 to a low point of $150. During this period IBM kept repurchasing its stocks at the low market prices.
In the transformation in 2014 the revenue of its big data analytics grew 7% to $17 billion and its cloud business grew 60% to $7 billion. These two together accounts 25.8% of IBM's total revenue and grew by 16% in 2014.
IBM is doing the following three things that I think its stock holder should really appreciate.
Firstly, it divested the low value business, especially the hardware related business. Hardware business is always requesting lots of extra capital than software and service oriented business. Generally speaking companies in hardware centric business as a whole are doing worse than companies in software and service business. The only company that is doing really well is Apple, a very special case. Divesting the low value business will increase IBM's return on equity and future profit growth rate.
Secondly, IBM is focusing on the right business, cloud computing and big data analytics. Cloud computing is the fastest growing area in IT industry. Its on-demand feature makes using computers similar to consuming electricity - you pay only for what you have used. That will save enterprises a lot of cost on IT infrastructure. On one hand, small and middle enterprises like to transfer their IT infrastructure to public cloud based system. On the other hand big enterprises definitely refuse to put their data in public cloud due to security concerns. IBM's hybrid cloud solved that problem for big enterprises. Although other competitors will roll out the similar services finally, IBM is in a leading role in this direction.
It is an industry for big service providers because building the data centers needs a lot of capital. The more customers a provider has, the cheaper its per-user cost will be because the initial huge cost of building data centers will be even out into many customers. From this point of view big providers are low cost producers. There will be no room for small players in this field for the long term.
So far the main players are Microsoft, Amazon, IBM, and Google. In the process of years of enterprises "cloudizing" their IT infrastructure a big player will harvest big profits if it doesn't make fatal mistakes and therefore can successfully share a good percentage of the whole market. Forget IBM's all other business, 10 years later only the cloud computing itself may make IBM worth more than its today's total value. IBM's reputation and technology are still excellent. Converting their existing customers to use cloud (or up sell cloud to them) shouldn't be a difficult thing.
An important fact here is cloud computing is in its very early stage. It has developed for a while and just finished its market acceptance stage. More and more companies are working on switching to cloud. After the several key controlling infrastructure providers push everything into cloud the old infrastructure will be obsolete eventually. Enterprises will have to use either public/private cloud or hybrid cloud. Cloud business is going to boom for years. Investing into IBM is a smart way to invest into cloud business. Here is why. The percentage of cloud business over the whole business of IBM is much larger than its competitors such as Microsoft, Amazon, or Google. Microsoft has big chunk of business on Office, Windows, Bing, etc. Amazon has its tradition ecommerce business. Google has its main business of search engine. The cloud business in these three companies is dramatically "diluted" by their other businesses. In IBM it is a different story. IBM's existing customers will be converted to cloud users. The cloud business will become a core business of IBM.
The key question for the financial community is whether IBM can deliver what they promised or not. There are a lot of people doubting about this. I believe they will finally deliver the result, especially on cloud computing, but it will take some time. For now they already delivered partially the cloud business with annual revenue of $7 billion, a 60% increase from previous year. I don't see any reason that the cloud growth will stop.
The Big Data analytics is a very good business with good return on invested capital and decent margin, but I think it will play a second role after cloud in IBM. Big data analytics will help enterprises on their decision making. It will eventually become a service like what Enterprise Resource Planning system is to a manufacturer. It will become a integrated part of any middle and large business. You won't have much advantage over your competitors when you have the big data analytics. But if you don't have it you will have a big disadvantage. The big data will help the business all over the world as a whole but won't help a specific business over another for the long term. During this process a big data analytics service provider still will harvest big profits.
The mobile and security business can be small and can be big too, but it is hard to evaluate for now. They play a key assistant role to help cloud business though.
Thirdly, IBM keeps repurchasing stocks. Stock repurchasing in a very low price earnings ratio will benefit stock holders a lot. I like to use an extreme example to show how this works. Suppose that IBM has a consistent P/E of 14 and stable earning power to support the P/E of 14. You are lucky enough and bought 1 share at cost of $200. As a high tech company with a decent return on equity, let's suppose 90% of its earnings can be freed to use for share repurchase, with 10% to enhance its business operation. If the stock price doesn't change and IBM keeps repurchasing the shares using its 90% earnings each year, about 16 years later it will repurchase all the outstanding shares except for the 1 share you own. Now you own the whole company and turned $200 into $160 billion in 16 years, an annual return of 360%. Of course in the real world you won't get so luck as the stock price will increase and IBM won't be able to buy back all the shares with such a low price. But the stock price will go up for sure and the earnings per share will be positively increased by the repurchasing. I don't understand why there are some people that always accuse of stock repurchasing. As a stock holder I personally prefer that IBM uses all its free cash to repurchase shared instead of distributing dividend. Here I feel so sorry for the people who hold cash or bonds. The interest rate is kept so low for recent years for the purpose of stimulating the economy, for example expanding manufacturing actions, creating job opportunities, etc. But lots of companies leverage the low interest rate to issue tons of debts to do record level stock repurchase, which, through inflation, intensifies the current stock holders' assets by taking money from people who hold cash. It is an action of benefiting staying stock holders by taking advantage of selling stock holders and all other people who hold cash.
The reason that last several years' revenue and profits of IBM are dropping is not because the quality and reputation of its products and service is decreasing. It is because the world has changed and they were slow to make adjustment to adapt to the external changes. They did a good job in transformation in the last couple of years and their strong global brand will finally kick in to help their growth of profits. The revenue of their traditional business may still decrease in the following several years even after the divesture but the decreasing speed will slow down. In the meantime their new business lines (cloud and big data) will grow dramatically. When the amount of revenue decrease in the traditional business equals the amount of increase in the new business, the pivot point will appear. After that IBM will see years of revenue and profits growth. At that time all the stock repurchasing effect will kick in and the profit growth rate will justify a high price earnings ratio which will create an even higher stock price.
That will happen and hopefully it won't take too long. All you need is patience. A successful investment doesn't have to be very complicated. You only need to do it like a business man, finding the great business (like cloud) in its early stage, joining them, and waiting for the great result with patience. It will be similar to investing in Apple when its first iPhone came out or Monster Beverage when energy drink started to be accepted by the market.
2. Industry Tail Wind and Head Wind
IBM's new cloud business has strong tail wind. Could is in its early stage and will grow into multi-billion dollar business. There are only limited big players are going to survive and each of them will be able to share part of the market with great profits.
Its big data analytics has some tail wind too but the potential is smaller than its cloud business.
IBM's old hardware related business has strong head wind. Some of the head wind is actually caused by the growing cloud business all over the world. When enterprises switch their IT infrastructure into cloud based solution, they will need less PCs, servers than before. The need for servers by cloud data centers will be much smaller than by enterprises if there were no cloud solutions.
One good thing IBM is doing is cutting back its business that has head wind and focusing on the right business that has strong tail wind. Obviously their corporate financial analysis department did a good job to help make these transformation decisions.
3. Financial Strength
From IBM's finance statement of 2014, its income from continuing operations before income taxes is $19,986 million. Its interest is $484 million. The coverage rate is 19986/484 = 41. Its net income is $12,022 million and its total debt is $40,800 million. Four years of its total net income can cover its total debt. From the above numbers IBM's finance status is very strong. Actually I am not sure how useful this kind of analysis is. It may give you some rough idea on how strong the company's financial status is. But for a company such as IBM with strong brand, earning power, and tail wind in high-tech industry, its financial status should be trustworthy.
4. Long Term Competitive Strength
Business wise, IBM has strong customer franchise and global brand. On one hand, a purchaser chooses IBM's system over other small competitors will have a smaller chance to lose his job if the system doesn't work very well. Purchasing from IBM is an easy, safe job. On the other hand, IBM's products and services have generally a better quality than other competitors, for many years.
Technology wise IBM is not as strong as the other two big competitors. But IBM is still in a leading role. With such a strong tail wind and a booming business IBM should be doing great.
5. Return on Equity (ROE)
When calculating ROE I only consider the earnings, assets and liabilities for the purpose of regular business operation. Any items that are one time or non-business operation related should not be considered. Please refer to my post on why ROE is important to a company and how to calculate ROE accurately.
From IBM's Annual Report of 2014, its total assets are $117,532 million. It has $3,104 million intangible assets. Therefore its tangible assets are $117,532 - $3,104 million = $114,428 million.
Its total liabilities are $105,518 million. Some of the long term debt is used for stock repurchasing purposes and therefore should be excluded from total liabilities when calculating ROE. For simplicity purpose I exclude half of is long term debt and the total liabilities in consideration is $105,518 - $(35,073/2) = $87,982 million.
The total tangible equity is $114,428 - $87,982 = 26,446 million.
The new income is $12,022 million, and the ROE is as follows.
ROE = $12,022 million / 26,446 million = 45%.
Note that you should calculate the ROE based on business operation. In its 2014 annual report its Total equity is $12,014 million. That number should not be used for calculating ROE.
IBM's ROE is higher than a regular business and is very competitive. That will allow IBM to free a big percentage of its earnings for dividends and stock repurchasing. Its loan receivables and leasing receivable is an interesting part and is a pretty big chunk in its assets. I don't like this part of its business as it depends on its borrowers' credits. Also a more accurate calculation of ROE should exclude this part of data. I believe as it builds more data centers and gets more cloud customers its ROE should increase.
6. Management
Virginia Rometty is an efficient leader. Since she joined IBM in 1991 her excellent performance helped her to become the CEO. Her strategy plan for IBM's future to focus on cloud and big data makes perfect sense. Her execution ability is strong and that already helped to achieve partial result on cloud computing. As long as she is committed to the business transformation that is happening now, success is just a matter of time.
One key fact about Virginia Rometty is that she has engineering background with a bachelor degree in Computer Science. I feel more comfortable to put my money in IBM's hand because of this. In a fast changing technical world with severe competition, I always believe that a company's chief leader has to have a technical background in order to make the correct decision at some critical times unless the leader is the initial creator of the company.
7. Valuation and Stock Price
IBM's traditional business revenue is decreasing and its new business (cloud, big data) revenue is increasing. When the annual increasing amount of the revenue becomes larger than the decreasing amount of revenue, its total revenue is going to start to grow. The growth rate together with the dividend rate will decide the value and therefore the long term stock price of IBM. Usually it is hard to predict an earning power of a technology company. But it is helpful to estimate a rough range of the stock price.
The valuation equation is as follows.
Stock Value = (earnings per share) * (8.5 + 2 * average growth rate for next 7 years)
From its 2014 Financial Statements its Earnings per Share (EPS) for continuous operations is $15.59, and for discontinued operations it is $(3.69). I will discount the discontinued one by 50% to get the effective EPS as $(15.59-3.65/2) = $13.76.
Based on the above information we can get the following table.
Average Growth Rate | EPS ($) | Value/Long Term Stock Price |
2% | $13.76 | $172 |
3% | $13.76 | $199 |
5% | $13.76 | $254 |
8% | $13.76 | $337 |
10% | $13.76 | $392 |
As for what the next 7 years' average growth will be, everybody will have his own number. My number is 8% but it is very rough. The only meaningful point of the table is it gives me a bottom line and tells me what stock price is a cheap one. 7 years is a short period for long term investment. Once I buy IBM, I actually expect it returns me a lot more value than the above numbers with dividends, stock repurchase, and stock price appreciation.
8. Psychologically Expectation - Price Drop and Patience
Setting up a realistic expectation for your investment can help you a lot when the stock prices fluctuate. Two worlds are created when you buy a stock. In one world, you got a kind of a certificate showing that you own a symbol that has an ever changing price tag shown on all type of charts (let's call this Symbol World). In the other world, you actually invest into and partially own the business that is operated by its employees all the time (let's call this side Business World). Obviously the Business World decides the Symbol World for the long term, and not vice versa. Unfortunately most of the people naturally step to the Symbol World and stay away from the Business World.
In the Symbol World when the price of a stock fluctuates lower than your purchasing price, which happens all the time, the fear will usually occupy you. The lower the price goes, the more fear and even pain you will feel. The result is usually you are going to sell the stock when you feel too fearful and painful to bear it any more. And that is, most of the time, when the stock price is at the bottom.
One way to overcome this situation is to know the business of the company underlying the stock by going into the Business World. When you are in the Business World, you will pay more attention to the business itself by knowing the business like a business man. You will roughly know how much it is worth, how the future earning power is, how competitive the product/service is, what you should do to increase the value of the business, what new products are in the pipeline, etc. That will help you understand whether the current stock price reflects the value of the business, and help you to avoid either paying too much for a stock or, selling a stock in a too low price. It also helps you to get more patience when it takes some time for the stock's value to catch up with its price. My experience is when you know the underlying business very well it is much easier for you to overcome the fear and pain caused by the stock price fluctuation.
IBM's stock price could still drop further to a very low level (for example, $110), or stay flat for a longer period (for example, 3 years) than you expect. If you stay in the Symbol World you won't feel very good when its stock price fluctuate lower. You might feel that your invested money becomes less. But if you enter the Business World, your attention will be focused on what IBM is doing to expand its cloud business, how many of its existing customers will subscribe its new line of services, how much it will spend on stock repurchasing, how the EPS will be increased, how much cash you can get from the dividends, etc. As long as the fundamentals show it is a great business with a fair price, you won't get scared to sell the stocks at wrong time as you know there is a day the value will pass its stock price and the price has to go up. At that day, say 10 years later, you look back with big profits, you will regret for all the time you spent on staring at the stock tickers. Staying in the Business World will help you to behave like a business men with precious patience to wait for the great things to happen, and save you time for you to enjoy life.
Happy Investing!