IBM Continues To Crumble

| About: International Business (IBM)
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Summary

IBM has been in freefall for better than three months.

The company is directionless after decades of the same broken strategies.

I think shares still have substantial downside potential as EPS estimates for the future continue to erode.

Shareholders of IBM Corp. (NYSE:IBM) have had, well, let's say, an "interesting" year. The stock has been wildly volatile, as IBM's leadership team, financials and strategic direction have all been in doubt in investors' collective minds. This has led to some downright horrendous performance in the stock, and has turned Big Blue into the Big Bruise for investors. I personally have not been a fan of IBM, as I think the company lacks a direction - any direction - after years and years of trying to engineer profits via crafty financial dealings instead of growing the actual business. But, for whatever it's worth, IBM has declined quite substantially this year, and in light of that, I'll use this article to assess if the pain may be over soon or if the falling knife should be avoided.

To do this, I'll use a DCF-type model you can read more about here. The model uses basic inputs including earnings estimates, which I've taken from Yahoo, dividends, which I've set to grow at 4% per year, and a discount rate, which I've set at the 10-year Treasury rate plus a risk premium of 5.75%.

2013

2014

2015

2016

2017

2018

2019

Earnings Forecast

Prior-year earnings per share

$16.64

$16.12

$16.82

$17.81

$18.87

$19.99

x(1+Forecasted earnings growth)

-3.10%

4.30%

5.93%

5.93%

5.93%

5.93%

=Forecasted earnings per share

$16.12

$16.82

$17.81

$18.87

$19.99

$21.18

Equity Book Value Forecasts

Equity book value at beginning of year

$14.40

$26.12

$38.37

$51.42

$65.34

$80.19

Earnings per share

$16.12

$16.82

$17.81

$18.87

$19.99

$21.18

-Dividends per share

$4.40

$4.58

$4.76

$4.95

$5.15

$5.35

=Equity book value at EOY

$14.40

$26.12

$38.37

$51.42

$65.34

$80.19

$96.01

Abnormal earnings

Equity book value at beginning of year

$14.40

$26.12

$38.37

$51.42

$65.34

$80.19

x Equity cost of capital

8.00%

8.00%

8.00%

8.00%

8.00%

8.00%

8.00%

=Normal earnings

$1.15

$2.09

$3.07

$4.11

$5.23

$6.41

Forecasted EPS

$16.12

$16.82

$17.81

$18.87

$19.99

$21.18

-Normal earnings

$1.15

$2.09

$3.07

$4.11

$5.23

$6.41

=Abnormal earnings

$14.97

$14.73

$14.75

$14.76

$14.76

$14.76

Valuation

Future abnormal earnings

$14.97

$14.73

$14.75

$14.76

$14.76

$14.76

x discount factor(0.08)

0.926

0.857

0.794

0.735

0.681

0.630

=Abnormal earnings disc. to present

$13.86

$12.63

$11.71

$10.85

$10.05

$9.30

Abnormal earnings in year +6

$14.76

Assumed long-term growth rate

3.00%

Value of terminal year

$295.22

Estimated share price

Sum of discounted AE over horizon

$59.09

+PV of terminal-year AE

$186.04

=PV of all AE

$245.13

+Current equity book value

$14.40

=Estimated current share price

$259.53

We can see something quite extraordinary here; the model has produced a fair value for IBM of $260. This is a full $100 higher than the current share price. But before you click away from this article and write me off as a nincompoop, please, allow me to explain. The model is intended to provide a fair value entry point that allows for a margin of safety in a stock. Given that IBM is $100 below the fair value price, it may look pretty enticing. However, the model is only as good as the inputs, and that is where our discussion begins.

I mentioned analyst estimates are used in the model, and I'd like to start there. Estimates have been falling like a rock for a while now, with next year's EPS coming down a full three dollars in just the past three months. That's all kinds of ugly, and it means that even the Street is losing faith in IBM's ability to execute. And that's the problem with IBM's valuation; what are you valuing? You're valuing a business that has no book value (thank you, Peter Greulich, for another excellent article), no discernible strategic direction and a long history of trying to game the system instead of growing the business. The problem is that only works for so long, and eventually, the business catches up.

IBM is currently trading for only 9 times next year's earnings estimates, which sounds cheap, but the problem is nobody knows what next year's earnings will be. Sure, it's nine times the current estimate, but that same estimate was $3 higher in September than it is now; imagine what it will be in March or June. In other words, any valuation of IBM right now is a bet that EPS won't continue to get hammered into next year, and right now, for the reasons I've stated, I'm not willing to make that bet.

IBM has become a black hole that takes investor capital and wastes it on never-ending attempts to engineer a way to EPS growth, regardless of whether or not it's working. And the model's fair value calculation illustrates to me that investors have absolutely zero faith in IBM's ability to execute, because if they did, the stock would never have reached $157; it would have been bid up a long time ago. But no one trusts the numbers right now, and that's a serious problem for bulls.

This chart of IBM against its Dow 30 (NYSEARCA:DIA) brethren bears out just how horrible IBM has been in recent years.

There are few charts in the financial world that look worse than that (except maybe crude oil (NYSEARCA:USO)), and it's because the game IBM has been playing for many years isn't working. Investors have figured out this is a dying business and that the buybacks aren't enough to float the ship any longer. IBM is on pace to produce roughly the same amount of revenue it did in 2004; consider that one for a moment in the context of the chart above.

Though I sound quite negative, I don't have anything personally against IBM; I just loathe the fact that a company's management has been focused on engineering EPS growth rather than focusing on its people and its business for so many years. The roadmaps that were to double EPS through little actual production but lots of financial games built a house of cards with IBM that has subsequently come crashing down. I honestly don't see what Buffett sees in IBM; I just see a business that is shrinking, and clueless management. And yes, I know he's the best investor of all time, but he's wrong sometimes too.

Forecasting a fair value on IBM is difficult, but I do know that it's lower than $157. I think we'll continue to see EPS estimates fall as it becomes more and more apparent that the business is shrinking and that the substantial buybacks will have to slow, exacerbating the decline in nominal earnings. This story is just beginning to play out, so I'd have a fair value price on IBM of about $120 right now. With no book value and a shrinking business, it's tough to want to put any price on this thing, but $120 is fair for where I see earnings going. I don't see IBM's lack of direction changing anytime soon, because it doesn't seem to matter who's running the place; we get the same thing year after year. And thus, down come the EPS estimates.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.