Download - IBM Intrinsic Value · IBM has a low P/E which makes it attractive to potential investors as the company is not overpriced. Currently, IBM has a P/E of 12.1 while the industry average

Intrinsic Value Assessment of

INTERNATIONAL BUSINESS MACHINE (IBM)

September 27, 2017 This article was written in collaboration with Eoin O'Byrne

a friend of The Investor’s Podcast

ThisassessmentwasconductedfromthetoolsprovidedinPrestonandStig’sIntrinsicValueOnlineTrainingCourse.

IntroductionInternationalBusinessMachine(IBM)isasignificantcomponentofthetechindustry,butitisnotpartoftheillustriousFANGstocksthatpropelthismarketsegment’sgrowth.ThreeofthesestockswereunpursuedopportunitiesandmajorregretsofCharlieMungerandWarrenBuffett.Meanwhile,investinginIBMwasanotherregretoftheseinvestors.

Overthepast52-weekperiod,thepricebandforIBMhasbeenbetween$182.79and$139.13.Thestockcurrentlytradesataround$145--abovethislowpointrecordedinAugust.Thisstockislanguishingatsomeofitslowestlevelssince2010.

IBM’sIntrinsicValueThecompanyhasmaintainedasteadycashflowoverthelast10-yearperiod.Thisconsistencyisessentialforapotentialstockpickasitshowsacompanythatcanmaintainandcontrolitsearningswhilekeepinganeyeonconsistentgrowth.Freecashflow(FCF)persharewasatitshighestlevelinadecadein2016at$15.02ashare,showingsteadyandcontrolledFCF.

Usingaprojectedcashflow,setting2007asthebase,andfollowingthetheoryofreversiontothemean,IhaveestimatedapotentialFCF.

Usinganupper,middle,andlowerband,wecanpotentiallyseetheprojectedvalueofthisstock.Myprojectionoftheupperbandis5%growthbasedonanincreasedtrendofthisremarkablyconsistentcashflowgeneratingcompany.Thelikelihoodofthisbandbeingachievedoverthenexttenyearswassetat10%.Thispercentagewasreachedbasedoncurrentmacroclimatesinwhichweareinthesecond-longestbullmarket.Meanwhile,itsprobabilityoflastinganotherdecadewasindecimalpercentages.

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Themiddlebandwascalculatedthroughreversiontothemean,anditslikelihoodwassetat65%withalevelofgrowthof0%.Finally,thelowerbandwassetat-5%whichwasthelargestleveldroppedovertheperiod.Alikelihoodof25%wasgiventothisband.Igavesuchalikelihoodbasedonhowlongthispeakinthecyclehasbeendrivenbytechandhowapotentialrecessioncouldadverselyaffectthiscompany.

Thebusinesshasbeenstagnatedforquitesometime,andthelargestrevenuesegmentsareunderalotofpressure–perhapsevenfacingalong-termdecline.Havingcalculatedthis,IbelieveanInternalRateofReturnof7.8%canbeachievedoverthenext10-yearperiod.

IBMhasalowP/Ewhichmakesitattractivetopotentialinvestorsasthecompanyisnotoverpriced.Currently,IBMhasaP/Eof12.1whiletheindustryaverageis18.1.ThismeansIBMcosts$12.1toearn$1basedonthecompany’searningsgeneratedoverthelast12-monthperiod.Asyoucanimagine,thelowerthisgoes,themoreattractivetheownershipofthiscompany’ssharesaretoavalueinvestorastheyareseentobetradingatadiscount.AnotherattractivefeatureofIBMisthequarterlydividend,whichiscurrentlya4%annualdividendyield.Thiscanbequiteahealthyyearlystipendforthoseinvestinginthestockforthelonghaul.Thepayoutratioof43.5%translatestoa$6dividendpershare.Thegrowthofthedividendhasbeenincreasingfor17yearssince2007andhasbeencontinuouslypaidsince1913.

IBM’sCompetitiveAdvantageAfeatureofIBMthathasthepotentialtoraisethiscompanybackupfromitsslowdeclineasamajorplayerisWatson,theAIandsophisticatedanalyticalsoftwaremachine.Thismachineisaimedatenhancingcompaniesandimprovingtheiroverallperformance.CEOGinniRomettysaysWatsonwillperformina“vertical”fashion.Inotherwords,itwillbetaughtthroughalgorithmicprogrammingtoworkeffectivelyandinabespokemannerfortheuser,i.e.thecompanyowner.So,Watsonwillnotonlybeoneproduct.Itwillactasauniqueoperatingsystemandanalyticproblemsolverforeachcompany.Thiswouldessentiallycreatea“myAI”typeofproduct,asRomettysaidduringarecentinterview.Thiscreatesasituationwherecompaniescanhaveanever-evolvingalgorithmthattheycangrowanddeveloptodetectanyfinancialfraudinthecaseofabankorselectsitesforpotentialdrillingforoilcompanies.Thisoneproductcanbecometheultimateinternationalbusinessmachine.Theareasofcognitivesolutionsandcloudplatformsshowgreatreturnsforthecompanyandamountto43%oftotalrevenue.






AnotherareawhereIBMcouldbeapotentialleaderisinblockchaintechnologies.Currently,IBMisleadingthechargeandisseenasbeingbetterequippedandpreparedthanrivalslikeMicrosoft.Thismarketspaceisnewandanythingbutcertain.Asapioneerinthisarea,however,IBMhastheopportunitytocreateandestablishbrandloyaltyamongfutureusersofthispotentiallydisruptiveemergingmarketspace.Thisbrandloyaltyisamajormoatthatthecompanycurrentlypossessesandcontinuallymaintains.

Infocusingonwherethecompanyisheading,wemustlookatwhereIBMhascomefromaswell.Attheendoftheday,IBMhasaverystrongmoat,andthatisitsbrandpower.Traditionally,thenameIBMissynonymouswithreliabilitynotonlyinitsproductsbutalsowithitsreputationasacompany.Whilethecurrentslowdowningrowthandthecurrentmanagementhavenotimprovedtheirreputation,IBMcanstillbeconsideredastrongbrand.Thecompanyhasastrongpresenceinitscorebusinessoftechnologyhardwareamongmanylargecompanieswithmainframesandotherofficetechs.Themovementtocloudstorageisstillmanyyearsawayfromtotaldominance.Atthismomentintime,themajorityofstorageisstillphysical,andIBMhasthatareasewnupwithacontinuedrevenuesourcestemmingfromit.Yes,therewasmostcertainlyareductioninrevenuefromhardwareamountingto$2.1bnin2016down9%fortheyear.Otherareassuchasglobalbusinesssolutionsandcognitivesolutionsaccountformorethan50%ofIBM’srevenueannually.Thisshowsthatthisareaofthebusiness,whereitisoftencriticizedforbeingoutoftouchwiththemoderneraoftechnology,isgeneratinganenormousamountofrevenueforthem.

IBM’sDrawbacksThiscompanyisnotwithoutitsnegatives.AmajorstumblingblockinthewayofIBMiswhatcomesupassoonasyousearchthecompanyonGoogleandthatisWarrenBuffettandCharlieMunger’sdisappointmentintheirinvestmentinthecompanyandhowtheyregrettheirinvestment.Thisisobviouslynotanimageanycompanywantstobeassociatedwith.

Thecompanyisalsoaggressiveinitspursuitofstockbuybackswhilecreatingstockintheformofcompensationtoemployees.Since1999,IBMhasrepurchased75millionsharesonaverage.Thisstaggeringamountofbuybacksisconstantandplannedalmostlikeadollarcostaveragingapproachbyaninvestor.Thisapproach,however,hasnotyieldedthedesiredreturnsasthevalueofthestockhasnotkeptupwithinflationandwasmorethan70%offinkeepingtrackwiththeinflationratesfrom1999to2016.ThisapproachhasbeenconsistentacrossallthreeCEOswithinthistimeframe.ThislackofchangefromaplanthatisnotyieldingthedesiredeffectisaworryingtraitwithinIBM.Theirdecisionmakingcandefinitelybequestionedinthisinstance.

ThevastarrayofcompetitorsacrossdifferentmarketspacesthatIBMworkswithinaresignificantfactorsaswell.Incloudcomputing,youhaveAmazonandGoogle.Inanalytics,thereareOracleandMicrosoft.Thislevelofcompetitioncanbegreatandspuringenuity.However,itappearsthatIBMiscomingoutsecondbestinthesematchups.Moreover,thistrendmaycontinueunlesstheyfindawaytobecomethetopdog.Meanwhile,competinginsomanyareasmeansthatfullattentioncannotbegivenspecifictasks.Thiscanbeahindrancetoexcellence,meaningIBMgetscaughtbetweencontinuingtheirlegacytechhardwarebusinessandinnovatingincloud/analyticservices.Thisisgettingreflectedintheirreturnstodate.Theirtotalreturnsrecentlyarelanguishingbehind--InfoTechServicesisup5.73%whileS&Pisupover18%YTDandIBMare-9.05%.TheseworryingfiguresareperhapsshowingIBM’slackofabilitytocompetewiththeirmajortechstocksrivals.

SummaryTheslowerosionofIBM’scorebusinessaspectsisanareaofworry.Lastyear,earningspersharedropped9%.ThisareaofIBMissuchalargerevenuegeneratorthatsuchafallissomethingtothinkaboutwhenappraising.Withthatinmind,returnswillnotbeseenforalongtime.However,itstillhasmanyfeaturestomakeitacompellingbuyandholdsituation.Withtheshort-termdrawbacksandthelong-termpotentialforthis






companyinWatsonalongwiththeirentryintotheblockchainmarketplace,Iseethiscompanybeingatasatisfactorylevelforfuturegains.

Withthesteadyinflowcreatedbythedividend,itlendsitselfwelltoalong-terminvestment.Letmeexplainitusingthisexample:IfyouholdoneshareofIBMfor10yearsanditfallsto$90ashare(37.5%drop),youwillhavecomeoutwithapositivereturnduetothecontinuousdividendthathasbeenincreasingforthelast17years,whichincludedthetechbubbleburstingandthefinancialcrash.

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