Evaluating the Future of IBM

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ibmSometimes, companies live so long that they outgrow their names. So it is with IBM (NYSE: IBM). The company, which has its origins in the 1880s, changed its name from the Computing Tabulating Recording Company, or CTR for short, to International Business Machines in 1924, to reflect more accurately its core businesses. But today, making machines – in this case, computers and their components – isn’t IBM’s core business any more. It’s computer software and services, and it’s aiming at the burgeoning markets for Cloud computing, Big Data and mobile applications for its business analytics software. Grasping the impact of that transformation is the key to evaluating the future of IBM.

IBM – which introduced the Personal Computer to the world – unloaded that business to Lenovo in 2005. Now, it has plans to sell off another big piece of its hardware-manufacturing business, its line of low-end computer servers, also to Lenovo. The move will make IBM’s Systems and Technology, its hardware division, an even smaller top-line contributor than last year, when it accounted for just 14% of sales. By comparison, its services businesses generated 58% of IBMs revenue and its software segment generated 26%. IBM’s global finance unit – which helps its customers by its products and services, made up most of the remaining 2%.

So what’s the reason for this strategic shift? It’s simple: profits. The computer hardware business generally doesn’t carry the margins that IBM’s is getting elsewhere: a gross margin of 34 percent last year and declining, compared to 89% in its software business and 38% in its global technology services unit. Company-wide, at the end of the second quarter, gross margins stood at 49% of sales, compared to 36% ten years ago.

The shift is responsible for the contrast in the growth of IBM’s revenues and operating income. Since 2004, the company’s revenues rose just 3.6% – less than 1% a year – from $96.3 billion to $99.8 billion last year.  But over the same period of time, operating income climbed 54.5%, from $15.9 billion to $25.0 billion, while net income nearly doubled, to $16.5 billion.

IBM has used its growing free cash flow to create shareholder value.  Over the last 10 years, it’s raised dividends at an annual rate of 21%, and through an aggressive stock buyback program, has reduced the number of shares outstanding to 998 million, IBM’s smallest number since 1999.  The effect has been a  tripling of earnings per share over the last 10 years, from $4.94 in 2004 to $14.94 in 2013.

IBM closed at $194.90 on Friday, July 25, at a PE of 13.29 and, with an annual $4.40 dividend, a yield of 2.26%. Nine consecutive quarters of revenue decline has cost the stock 15 points since reaching its all-time high of $215.90 in March 2013. Holding the stock price back is not simply the decline in hardware sales, but also in its service business recently, and softer-than-expected software sales growth.

But there are signs that, long-term, revenues will grow: senior management points out that the company’s analytics revenue has grown from $11 billion to nearly $16 billion from 2010 to 2013, and is on track to reach $20 billion by the end of 2015;  and Cloud-related revenues, which came in at $4.4 billion last year, are expected to push $7 billion next year. Another strong step in the right direction is a potential partnership it announced this month with Apple to develop apps to get IBM enterprise analytic software onto Apple’s mobile platforms.

From where I sit, IBM is one of the most attractively valued stocks in the Dow 30, and is a strong long-term “Buy.”  Its trailing PE of 13.29 is below IBM’s 13-year median of 14.47, and its forward PE against 2015 estimated EPS is just 9.80. It won’t take much of an increase in revenue growth to see those numbers expand.  A bump to a PE of 14.47 alone would bring the stock to $211.

Looking further out, the Street sees IBM earnings growing 8.78% a year for the next five years.  If that bears out, the stock could reach $230 by 2015, $250 by 2016, and $322 by 2019.  Throw in dividend growth of just 5% a year – allowing for the company to use its free cash to improve the balance sheet — and that translates into a very robust annual total return of 16.3%.  For a Dow stock, that’s hard to beat.

About Lawrence Meyers
 lawrence meyersLarry is regarded as one of the nation’s experts on alternative consumer finance. He consults for hedge funds and private equity via his Council Member status at Gerson Lehman Group, and as a member of Coleman Research Group’s Executive Forum. He also consults for Credit Access Businesses and Credit Services Organizations in Texas. His Op-Eds and Letters to the Editor have appeared in over two dozen major newspapers. He also brokers financing, strategic investments, and distressed asset purchases between private equity firms and businesses of all stripes. You can reach him at [email protected]

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