The Reasons for Under-Performance
IBM's shares have under-performed the S&P 500 index by 25% year-to-date. The reason can be found in the company's recently weak operational performance. Revenues dropped by 4% year-over-year and, normalizing for tax rate, earnings were 10% lower than consensus. Besides, most analysts remain concerned with weak free cash flow generation (which was down by 22%), weak hardware performance (down by 17% mostly thanks to temporary issues) and a less effective mix in software revenues. Analysts describe IBM's problems as being permanent. They usually write about IBM's ill-positioned hardware business and the fragmented software business.
That said, the combination of margin expansion, buybacks and cost cutting are still driving bottom-line growth – IBM is expecting net margins to expand to 19.1% in 2014 up from 17.9% in 2013 and operating margins should also expand next year to 24.8% from 2013's 22.5%. Moreover, analysts should consider the current context where companies have kept their IT spend at a very low level. Actually, I believe corporate spend in general should be about to boom, so top-line growth should also re-start for companies such as IBM.
Valuation Looks Very Compelling
As I always mention, “Price is what you pay and value is what you get.” Even when I need to admit that IBM's results during the last few quarters were indeed disappointing, I also need to mention that I believe the company's issues are more temporal than permanent and the company's long-term value still looks great.
Corporate IT bosses around the world trust IBM to solve their needs as much as they did a year ago. On top of this, IBM has generated a $8.2 billion free cash flow (FCF) year-to-date and I would expect the company to post a $14.8 billion FCF in 2014. This means that, during 2014, IBM should produce a FCF per share of $13.5. If my estimations are right, the company is now selling for 13 times 2014 FCF per share, which looks extremely compelling for a company which should resume top-line growth and is paying an always growing 2.1% cash dividend yield.
I truly believe most analysts are underestimating IBM's future potential. The company holds huge value and its management is a good capital allocator. Besides, management is also willing to share the company's cash flows with shareholders through higher dividends and share buybacks. I think that, one more time, Warren Buffet might be just right. All in all, you might want to consider IBM as a part of your portfolio.