What a month it has been!
I kind of feel like the old me. I used to deploy substantial capital with some frequency back when my income was significantly higher than it is now, but lately my stock purchases have been a bit more subdued both in frequency and amounts.
However, the stock market was unusually volatile over the last few weeks or so, and I often say that volatility is opportunity. So I decided to take advantage of that opportunity. Although stocks in general certainly aren’t cheap as a group, I pick and choose those businesses that I feel offer the best combination of value, quality, yield, and growth.
This is now the fourth stock purchase this month. This particular buy wasn’t planned at all, and I was quite content with riding into November with all activity related to the portfolio closed for the month of October. But the particular stock in discussion today fell to almost obscene levels, which gave rise to quite a bit of interest on my end. I dug deep into capital reserves for this purchase, so I anticipate that November’s action will be a bit quiet as a result. But the value here is, in my view, compelling, which allowed me to average down on my position in this company for the first time in more than a year.
It should be noted that this purchase was smaller than my usual transactions in regards to total cost, and this was due to the fact that this was pretty much all the cash I can spare at this time, as well as the fact that I have a few free trades stored up with Scottrade. So I was fortunately able to buy these shares commission-free.
I purchased 5 shares of International Business Machines Corp. (IBM, Financial) on 10/22/14 for $161.91 per share.
Overview
International Business Machines Corp. is a global information technology company operating across more than 170 countries.
They operate in five segments: Global Technology Services (39% of fiscal year 2013 revenue); Software (26%); Global Business Services (19%); Systems and Technology (14%); and Global Financing (2%).
IBM is shifting its business from lower-margin hardware to higher-margin software and sales. Unfortunately, there is some short-term pain for long-term gain as the business experiences transformation. The good news is that this is nothing new for IBM. They’ve been around for a lot longer than most tech companies, with corporate history dating back to 1911. As such, adapting to the times is nothing new for this company.
Fundamentals
So IBM sports slightly less excellent fundamentals than when I purchased shares last year. However, shares are down more than 10% in that time frame. I thought there was substantial value before, and I believe there’s even more value now.
Let’s take a look at what this company has produced financially over the last 10 years. Their fiscal year ends December 31.
Revenue has increased from $96.293 billion in FY 2004 to $99.751 billion in FY 2013. That’s a compound annual growth rate of just 0.39%.
Now, the flat revenue isn’t particularly inspiring. However, it should be noted that revenue growth isn’t the holy grail of growth for a company. Ultimately, profit and profit growth is what I’m after. Increasing revenue without also increasing profitability does very little for a company’s value and its ability to deliver value to me as a shareholder in the form of increasing dividends, buying back shares, and investing in the business. And IBM has been excellent over this time frame at increasing profitability even without sustained revenue growth due to a combination of additional efficiency, higher margins, and share buybacks.
That being said, I certainly would like to see IBM start to move the needle a bit at some point as there is only so much additional profit you can squeeze out of the same top line dollar.
One more quick note I’ll make on revenue growth is that there are a number of companies out there that typically go for long periods of time between growing revenue, but still end up being excellent long-term investments. Insurers in particular come to mind, as you can see with Travelers Companies Inc. (TRV, Financial)and The Chubb Corporation (CB, Financial) – two insurers I wrote about not long ago.
Earnings per share meanwhile grew from $4.94 to $14.94 during this 10-year stretch. That’s a CAGR of13.08%. Overall, I’m pretty happy with this type of growth in profitability, achieved through a variety of methods I discussed above.
S&P Capital IQ predicts EPS will grow at a compound annual rate of 5% over the next three years. I’m slightly more optimistic, as even recently reduced guidance still puts the company on track for 7% year-over-year EPS growth for FY 2014.
The share buybacks in particular have been aggressive: The company has reduced its share count from 1.65 billion to 1.05 billion over the last 10 years. So that’s certainly generated some of the outsized EPS growth relative to revenue. And while some may argue buybacks aren’t most effective/aggressive when shares are truly cheap, IBM just announced an additional $5 billion authorization on top of the current program. I suspect, due to the timing, this is to take advantage of the particularly cheap shares.
IBM sports even better numbers in the dividend department, which is something I definitely appreciate as a dividend growth investor.
IBM has increased its dividend for the last 19 consecutive years. Meanwhile, their dividend history is actually even more impressive, as they’ve been paying a quarterly dividend since 1916. I don’t know of any other tech company out there that can lay claim to something that impressive.
Over the last 10 years the company has increased its dividend at an annual rate of 19.4%. But even though the dividend has been growing at a more aggressive rate than the underlying earnings, the payout ratio still remains rather low, at just 27.6%. So the stock’s current dividend of $1.10 quarterly per share, which has resulted in a yield of 2.69% here, is well-covered.
IBM’s balance sheet is actually solid, though it seems to confuse some investors. The long-term debt/equity ratio stood at 1.44 at the end of FY 2013. This by itself seems a bit high, especially for a technology company. However, the interest coverage ratio, which measures a company’s ability to pay interest expenses with EBIT, is over 49. That’s extremely high, which indicates IBM is actually using leverage quite responsibly.
The debt/equity ratio appears high not because IBM is overly leveraged with a lot of debt, but because common equity is low as the company shifts from hardware assets to a more service-oriented business.
It seems some investors are concerned about IBM taking on a lot of debt to fund buybacks, but this just isn’t indicative of what’s really going on, and even if it were I’d be okay with it as I’d rather have expensive equity retired for cheap debt. I recently wrote about the potential value in The Coca-Cola Company (KO, Financial)and IBM after big respective drops. I found it interesting that a lot of people are concerned about IBM’s debt, but didn’t mention Coca-Cola’s debt at all. IBM has roughly doubled its long-term debt from about $15 billion to about $33 billion over the last ten years. Meanwhile, Coca-Cola has increased its long-term debt from approximately $1 billion to just over $19 billion during the same stretch. So KO increased their long-term debt load nineteen times over and now sports an interest coverage ratio that’s about half of IBM’s. I only reference this as an important point of discussion when determining whether the rumors surrounding IBM’s balance sheet are actually based in reality.
Speaking of big respective drops, IBM’s stock is down almost 14% over the last month after a rather disappointing third quarter report. I wasn’t particularly enthusiastic about the numbers myself, but I don’t see anything fundamentally wrong with the company that can’t be solved. They did notably abandon their $20 operating EPS target for 2015. It should be noted this wasn’t a GAAP EPS target and this target was actually announced before current CEO, Ginny Rometty, took over the company. Nonetheless, it was disappointing due to the company publicly and aggressively touting the figure.
Furthermore, the backlog for the company is down 7%. However, it’s still a monstrous $128 billion. In addition, the company announced the offloading of its semiconductor unit to Globalfoundries Inc., a transaction that IBM paid $1.5 billion to close. With all the recent divestitures accounted for, IBM has reduced revenue by about $7 billion. However, this $7 billion worth of business represented about $500 million in pretax losses. I love that management is offloading businesses that are actually losing it money, even if revenue drops. This allows them to focus resources on growth areas.
Profitability looks extremely sound for IBM. I discussed earlier that the company has been moving away from business with lower returns to business with higher returns. You can see this in the net margin: It has increased from 8.75% to 17.04% during the last decade. Return on equity has increased from 29.27% to 79.15% over the same period.
Qualitative Aspects
So the fundamentals look solid. But what about the qualitative side of the business?
Well, I think it’s important to note exactly what IBM is and does. It’s systematically moved away from hardware, as can be seen in most recently with the semiconductor unit sale to Globalfoundries and the x86 server business to Lenovo Group Limited (LNVGY). As these changes have occurred, they’ve increased revenue in enterprise software, services, and solutions.
IBM now focuses on three areas: data, cloud, and engagement.
IBM cites that data is the world’s new natural resource. I’m not sure how much hyperbole is involved there, but there’s no doubt that accessing and taking advantage of ever increasing amounts of data is becoming more commonplace. IBM’s expertise in these areas gives it a competitive advantage, because once it’s able to implement its infrastructure on the enterprise side, this creates a regular and reliable source of recurring revenue for the company.
So how does IBM plan to take advantage of data and analytics?
Through investment. They have invested $24 billion to date in Big Data and analytics and have landed more than 30 acquisitions in this area. IBM’s size and scale give it an advantage in this market because not only is it able to invest in its own expertise and platforms, but it’s also able to sweep up smaller companies when/where advantageous. Analytics revenue has increased from $11 billion to $16 billion from 2010 to 2013.
It seems some investors are disappointed with IBM’s use of cash, wishing them to invest in the business. But it appears to me that they’re already doing so; they typically spend about $6 billion in R&D each year.
Cloud is another growth and focus area for the company. Notably, 85% of new software is now being built for the cloud.
Again, IBM is heavily investing to ensure their competitive advantages stay intact. They’ve invested $7 billion to date to build out cloud capabilities, which has resulted in this: They grew cloud revenue 69 percent in 2013 and accounted for $4.4 billion in revenue for the company last year. The company now sports 40 cloud data centers across the globe.
So this investment has led to growth in key markets for the company. And it has also led to countless patents that serve as value for the company as well: 500 analytic patents generated every year, over 1,500 cloud patents, and 4,300 patents in mobile, social, and security technologies.
The company is also growing substantially in social, mobile, and security. All of these businesses are up significantly year-over-year, with mobile up 69% in 2013.
One of the main issues I see with IBM right now is that many of their fast-growing businesses are still relatively small parts of the overall business. But the moves they continue to make year after year are setting up the long-term vision for the company and allowing these businesses to grow while some of the legacy businesses slowly shrink.
It seems that betting on IBM here is really making a bet on the company, its legacy, its technology, and its management. I can’t think of any tech company that has adapted like IBM has over the years, and its move from hardware to software, services, data, cloud, and mobile is exactly what they need to do.
I’ve witnessed time and time again as tech companies have fallen by the wayside. I’ve watched a dominant company like BlackBerry Ltd (BBRY, Financial) become almost irrelevant in just a few years time. And you know how that happened? Change. BBRY didn’t change, and instead continued to milk a few products. No innovation. No adapting. I like that IBM is changes and adapts as necessary.
Risks
There are risks here with IBM, which should be carefully considered.
Primarily, they operate in highly competitive markets in a sector of the economy that undergoes significant change over time. IBM may not be able to change as quickly or adeptly as necessary to remain competitive.
The core business remains operationally challenged right now, which could lead to persisting problems. Revenue could continue to decline, which would eventually affect the company’s ability to increase profitability and dividends.
They’re also exposed to currency fluctuations due to their global position.
Valuation
IBM has some issues, no doubt about it. While the company has been particularly adept at increasing profitability, it will at some point need to move the needle on revenue so as to garner a larger pool of top line dollars from which to squeeze out even more profit. In addition, some of the areas of the business that are growing especially quickly still comprise relatively small parts of the company.
However, I ask myself whether or not these issues are insurmountable for the company? And I just don’t think they are. They’re positioning themselves well for the future by shedding lower-margin businesses that are losing money while focusing on businesses that are growing rather fast and offer much better profitability and visibility. This positioning is occurring through investment, acquisitions, R&D, and the shifting and alignment of focus within the company.
I often reference Warren Buffett (Trades, Portfolio)’s attitude on being greedy when everyone else is fearful. It’s precisely when a company is having issues, like IBM is experiencing right now, that represents the apex of opportunity. Business isn’t all rosy for IBM right now, but that’s exactly why shares are cheap here. If everyone wanted to buy IBM because business was great shares would be pricey. Consensus can be awfully expensive.
Shares are trading hands for a P/E ratio of 10.27 right now. That’s not only substantially below the broader market, but also below IBM’s five-year average of 13.2.
I valued shares using a dividend discount model analysis with a 10% discount rate and a 8% long-term growth rate. This growth rate seems reasonable, as their long-term dividend growth is more than twice this, and their EPS growth rate over the last decade is also significantly higher. The sky is falling for IBM right now (as the headlines would have you believe), and yet they’re still growing earnings by 7% YOY and dividends by 15.8%. These are lofty numbers that will require massive and permanent impairment to the business for the long-term growth rate to fall far below my forecast. Furthermore, the payout ratio is extremely low, which allows for dividend growth in excess of earnings growth for some time before becoming worrisome. The DDM analysis gives me a fair value of $237.60 on shares.
There appears to be a fairly large margin of safety on shares right now.
Conclusion
IBM is troubled right now, but it has a lot to be excited about. Shares are incredibly cheap, which means the recent additional buyback authorization will be accretive to EPS, and that’s before we even see more core growth. The company is making what appears to me to be the correct moves by shedding unprofitable businesses to focus on exciting, new growth areas that should propel the IBM of 10 or 20 years from now into a tech powerhouse. In the meanwhile, I expect the company to continue to deliver impressive dividend raises for the foreseeable future.
This purchase adds $22.00 to my annual dividend income, based on the $1.10 quarterly per share dividend.
I’m going to include current analyst valuation opinions below, as I use these to concentrate my reasonable valuation estimate:
Morningstar rates IBM as a 4/5 star value, with a fair value estimate of $196.00.
S&P Capital IQ rates IBM as a 3/5 star hold, with a fair value calculation of $205.00.
I’ll update my Freedom Fund in early November to reflect my recent purchase.
Full Disclosure: Long IBM and KO.
What do you think of this purchase? Think IBM is a strong value here? Think there are better opportunities in the market?
Thanks for reading.
