Artificial Intelligence and IBM's Long-Term Potential

Maybe Warren Buffett is holding on because he recognizes the power of AI

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Sep 27, 2017
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Artificial Intelligence is so hot right now. And out of the big three Microsoft (MSFT, Financial) Oxford, Google DeepMind and IBM (IBM, Financial) Watson IBM has both the advantage and more room to grow. With a market capitalization of $136 billion, it’s one-quarter the size of the other two but has less than half the earnings. The company also pays a 4% dividend, which is necessary at this point to attract investors since its revenue stream has been declining for years.

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The hope is that it’s spent all this time taking a step back to be in a position to take a few steps or giant leaps forward. Good news is that IBM’s gross margins and return on equity both remain extremely high while R&D costs are lower now than they were in 2007. And the company has Watson.

A recent report by Arm, a leader in semiconductor IP, showed that 61% of people see artificial intelligence as making the world a better place, 57% would prefer an AI doctor to perform an eye exam, and 55% would trust an autonomous car. The survey took people from the U.S., Europe and Asia. It’s important because AI adoption is coming, and business will be building deliverables on the back of platforms like IBM Watson.

My first thought is that another unknown company will come up and be the leader like Facebook (FB, Financial) did with social media in the early 2000s. Back in March, Mark Cuban made a ridiculous statement that the world’s first trillionaires are going to come from artificial intelligence entrepreneurs.

We’ll see. But that leaves hope for IBM to continue looking for and working with brilliant people. Just like Bill Gates (Trades, Portfolio) and Paul Allen used a massive contract with IBM to build Microsoft, someone could use it to build the next big thing. It’s likely to come out of AI.

Here’s more on how AI is changing your life.

Of course, recently IBM has been turning in quarter after quarter after quarter of disappointing earnings. Revenue continues to slip with declines in all five of its business segments. And while cloud computing continues to grow, rising by 5% in the quarter, strategic initiatives like this accounting for 43%, Big Blue’s sales aren’t sustainable as a business model. Management expects results to strengthen in the second half of this year, and EPS will likely be north of $12 per share with the company paying out 50% of that as dividends. As a dividend play, the stock is likely to produce better returns than inflation.

What we know for sure

IBM is going to continue to buy back stock, thus increasing its EPS number, which increases the dividends paid. If IBM is right with Watson, the AI platform for business, it would be in a position to not only increase profit but also see a multiple expansion as well.

The company's Cognitive Solutions (software) segment has been experiencing double-digit growth in Software-as-a-Service (SaaS), which should help it book recurring revenues. Global Business Services (consulting) has also improved after several quarters of declines with a stabilized backlog of work. All in all, the company will continue to remain profitable.

That’s not what Warren Buffett’s investment team is looking for, is it? Berkshire (BRK.A, Financial)(BRK.B, Financial) wants and needs growth unless it's going to pony up $136 billion in cash and stock to buy IBM outright. Not likely, especially as Buffett has pared his position from 81 million to 54 million shares over the last year. Getting in now under the $150 per share level presents an interesting question.

Can the price double in five years?

With Google and Microsoft trading at 33x and 27x earnings, if traders put IBM into that sphere, it would be good for a double right now. To get there it needs to stack up some wins. Microsoft had a lost decade and hasn’t exactly crushed it with growth during the last decade, but the stock price grew more than twice as fast as the Standard & Poor's because it improved. IBM can do the same from here.

Disclosure: I am not long/short IBM but may initiate a position in the next 72 hours.