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Warren Buffett's investment in IBM (NYSE:IBM) was his first bet in a large capitalization IT company. After making a $11.7 billion investment (acquiring more than 6% of the company's shares), IBM is now part of Berkshire's “Big Four” investments: American Express (NYSE:AXP), Coca-Cola (NYSE:KO), IBM and Wells Fargo (NYSE:WFC). Buffett made his bet when he saw that the company was successfully building a strong motto around its businesses. Or, in other words, Buffett saw that IBM was building sustainable competitive advantages that would give the company long-term pricing power. Right now, at a time when the S&P 500 index is beating historical records, the company is selling very close to its 52-week low. Should you make a bet on IBM's shares?
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.
Bottom Line
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.
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IBM is interesting. It's becoming a very feared investment because of concern around the unpredictable nature of the technology business.
Personally I think it's a buying opportunity because I think IBM will transition well in the long run though it may suffer pain along the way. I don't think this is like digital cameras destroying the film business for Kodak and I actually think IBM has been smart about selling off commodity businesses. Growing non commodity businesses has proved more challenging but I think that people underestimate the human element of technology services. If you are a large company or government that needs long term reliability, scale and reach... IBM is still very much a good bet. It's also easy to undervalue the existing client base and how expensive it is to switch vendors. That may hurt margins... But it also hurts competitors margins.
People mention oracle and sales force a lot...but I don't see them taking any meaningful chunks from IBM. Salesforce in particular has not set the world on fire lately.
The other frequently mentioned area is cloud. Cloud is a great technology but a pretty terrible business as Amazons recent quarter shows. Sure... AWS is an amazing service but I doubt large non tech corps and governments want to hire thousands of IT professionals to manage it. Maybe amazon gets into that game and competes but that will take time and I haven't seen that in their play book.
R&D is also criticized because of the ratio to stock buy backs and dividends. Fair enough but on an absolute basis IBM spends more on R&D than most tech companies and as such is likely to spot, develop and patent many critical future technologies whose value is hard to estimate. I think long term value of stuff like Watson is much bigger than optimizing my facebook news feed or my twitter retweet stats.
in terms of size, scale, reach and reliability I don't even know who the #2 company is.