IBM – Targeted to Compound at 7%

International Business Machines – Targeted to Compound at 7%

Overview

International Business Machines (IBM, Financial) is one of the world's largest suppliers of computer hardware products and IT services. While it was once the world's largest supplier of personal computers, IBM has largely transitioned its business out of lower margin hardware lines and into higher margin software and services. That being said, it does still continue to produce major system mainframes and network servers.

The company's major operations consists of five business segments: Global Technology Services, Global Business Services, Software, Systems and Technology, and Global Financing.

Global Technology Services is the largest segment, at 39% of revenue, and provides primarily IT infrastructure services (cloud computing, analytics and virtualisations) and business process services (software and transaction processing platforms). The Global Business Services segment (accounting for 19% of revenue) provides IT consulting, application design, and systems integration services. The Software segment (26% of revenue) supplies middleware and operating systems software to enable clients to integrate systems, processes and applications together. Systems and Technology (14% of revenue) provides semiconductor technologies as well as server and data storage services. The Global Financing segment (2% of company revenue) helps finance clients' purchases of IBM systems, software and services.

Purchase Considerations and Cautionary Notes

Once a heavily burdened manufacturer of low-margin consumer PCs, laptops, and hard drives, IBM has successfully converted itself into an IT consulting and business solutions powerhouse over the last decade. Furthermore, IBM has not missed a step on current IT trends calling for greater strategic focus on cloud computing and business analytic services, though neither have its competitors, leading to intense competition among major rivals. Buyer demand for website and mobile application development as well as data warehousing is growing steadily. IBM is well positioned to benefit from these trends.

IBM has also maintained a strong foothold in international markets and has a clear first-mover advantage in many emerging markets, helping it to maintain margins. We believe that its strong international presence will help support growth moving forward as the global economy strengthens. We also believe that as economic growth improves in North America, so too will IBM's sales. In addition, IBM has a highly valued patent portfolio and "top of the line" mainframe, server, semiconductor and software production facilities. They are an R&D leader and generate enormous cash-flows to support strategic acquisitions. We also like that management keeps their "eye on the prize," and does not seem to squander shareholder capital on low value-added activities.

Regular, rapid, and disruptive technological developments is what's most concerning about IBM's market space. The company must stay on track with technological changes and continue to find new ways of adding value for customers. Intensified competition on the software and service side with Microsoft, HP, and Oracle is also a point of concern. All firms seem to be merging towards a similar business model, are well resourced, and given limited growth on the top-line, will be fighting aggressively for market share. Within another decade, there is legitimate risk that IBM's basis of differentiation will be lost. Lastly, given IBM's high dependency on government contracts, budgetary cutbacks to cope with large deficits amassed during the financial crisis/recession could have a negative impact on IBM's sales over the next few years.

Historical Financial Performance

About $99,751 million in revenues moved through IBM's door in 2013. IBM’s revenues for the Dec 2004 to Dec 2013 period clocked in at an average annual rate of growth of 0.4%. While sales levels remain strong, the company has been virtually incapable of building new sources of sustainable growth over the last decade. Revenues grew at a annual rate of 0% over the last 3 years and fell by almost 1% annually over the last 5 years. That being said, year-over-year IBM continues to make substantial sums of money off revenues after subtracting costs of goods sold, with gross profits reaching $48,505 million in 2014. Gross profits have grown by 4% per year over the last 10 years and 1% per year over the last five years.

IBM's production costs appear well under control, with COGS falling by 2% per year over the last three years against revenue growth of 0%. IBM does not appear to be experiencing any difficulties passing on the cost of inflation to consumers. Gross margins have expanded from 37% in 2004 to 49% in 2013. In addition to being on an upward trend, IBM's gross margins are very strong. As a general rule, we want to see consistent gross profit margins above 40% for firms in the sector. IBM has been able to meet this requirement in nine of the last 10 years and was barely affected by the financial crisis/economic recession. Gross profits margins consistently above 40% for firms in the sector is, in our opinion, very likely indicative of a firm with a strong competitive advantage and substantial pricing power.

IBM spends between 50% of gross profits on hard costs associated with selling expenses, advertising, management salaries, payrolls, advertising and legal fees. We consider spending about 50% of gross profits on SG&A an acceptable result. Cost of SG&A, however, have been increasing at a stable rate, rising by 2% per year over the last 10 year and three-year periods. We consider this a negative sign when viewed against annual revenue growth of approximately 0% over the same periods respectively.

IBM has shown continued strength and reasonable stability in its operating earnings picture, rising by 8% per year over the last 10 years and by 3% per year over the last five years. The long-term trend in operating income has been upward, rising from $9,616 million in 2004 to $18,777 million in 2013. IBM has earned on average about 16% in operating earnings on total revenues over the last 10 years -- an acceptable result. IBM carries a moderate amount of debt on its books and, consequently, pays out about 2% of operating income on interest payments annually. This is a very acceptable result and lower than much of the competition.

Bottom line results show a strong upward long-term trend in earnings, with minimal volatility, growing at an average annual rate of 9% over the last 10 years. Earnings are expected to tick upwards in 2014 and 2015, as sales of higher margin software strengthen with the global economy. IBM’s strong competitive position has allowed it to maintain net margins of 16% and 15% over the last three-year and five-year periods. We do not expect to see much margin expansion from this company over the short to medium-term without a major uptick in mainframe and cloud-based sales.

Diluted EPS grew from $4.38 per share in 2004 to $14.94 in 2013. We like seeing that, since 2004, earnings growth has outpaced revenue growth by 9% per year. To us, this is a sign of earnings quality strength. We also like that the firm's share-base continues to fall, with diluted shares falling by almost 600 million since 2004. IBM's ROE and ROA performance continues to be exceptional, averaging 55% and 11% respectively over the last 10 years.

Table: Key Historical Financial Data

Return Estimation

Estimating what long term rate of return we expect on IBM’s stock is presented below. Estimates are built in four steps:

(1) We use econometric processes to make long-term projections of what the company will be capable of earning;

(2) We estimate a Bear, Bull, and Normal price earnings multiple by which to multiply our projected per share earnings to estimate the stock price 10 years out;

(3) We estimate cumulative dividend payments over the 10-year period; and

(4) We calculate an annual compounding rate of return based on projected dividend payments and the expected stock price.

Figure: EPS Projections

IBM’s per share earnings has grown by 15% annually over the last 10 years and holds a dividend payout rate of approximately 25%. Using econometric methods, we project that IBM will have per share earnings of $22.68 in 2023 reflecting stable sales, stable margins, and moderate capital expenditures. If IBM trades at Bear multiples, then the market price for the stock in 2024 will be $204.12. If IBM trades at Bull multiples, then the market price will be $521.64. Based on historical data, in normal conditions IBM trades at 14.5-times earnings. The price of the stock will then be worth $328.86. Bought today at $190.27, IBM would produce a before-tax compound annual rate of return of 5.6% excluding dividends. Assuming dividends remain at current levels, they would generate $48.01 in additional income over the forecast horizon. Added to the price of $328.86 the before tax compound rate of return estimate jumps to 7.1%.

Table 2: Terminal Multiple and Return Estimate

Conclusion

IBM produced an average annual return on equity of 55% over the last 10 years. This has increased to 79% over the last three years. Trading at $190.27 per share against three-year average earnings of $14.20 a share equates to an initial rate of return of 7.5%. We project that EPS will grow at a rate of about 4.3% over the next 10 years. IBM is expected to increase its dividends over the long-term and its adjusted debt load remains below 6x average annual earnings. Over the long-term, we expect to generate a compound annual return on IBM stock of about 7.1%.