Credit: Shutterstock photoIBM ( NYSE:IBM ) offers system hardware, infrastructure software, outsourcing and systems integration services, all within the IT industry. The company operates a global network that stretches across 150-plus countries and generates over half of sales outside North America.
The tech stalwart is currently under pressure (see sales chart below), as it is not well-positioned to benefit from the rapid shift in the enterprise market towards cloud computing. Historically the company heavily relied on selling mainframes and supporting services/software to large enterprises. This type of IT infrastructure is rapidly becoming obsolete, with companies instead buying processing power on demand in the cloud.
In my view, this mega cap is undervalued, which is confirmed by the great interest among gurus. Among the greats who own the stock are Warren Buffett ( Trades , Portfolio ), Prem Watsa (Trades, Portfolio), Jeremy Grantham (Trades, Portfolio) and Joel Greenblatt (Trades, Portfolio) and others.
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Management
Ginni Rometty is chairman, president and CEO of IBM since early 2012. She joined IBM back in 1981 and was elected SVP of Global Business Services in 2005, SVP of Sales and Distribution in 2009 and SVP of Sales, Marketing and Strategy in 2010. Results under her leadership have continued to be impressive, with ROE around 20% to 30%. ROIC under her leadership has been equally impressive. Rometty has chosen to sell off non-core businesses and the OpenPower program, which began in 2013, is growing quickly. In some ways her leadership reminds me of that of the increasingly popular Satya Nadella at Microsoft ( MSFT ). The shareholder letter in the annual report is refreshingly clear and explains the transition the company is undergoing, while highlighting some of IBM's strong suits:
Risk factors
IBM is building out software-as-a-service solutions and adapting its business to customers' needs in a cloud-based world. If the firm fails to make this transition at a fast enough pace, it will continue to lose revenue. My concern is somewhat mitigated as the firm produces IP at an extremely high pace (7,000 patents last year), and derives revenue streams from its technological solutions. In addition, some IT services will still be required and they are only a small expense to customers, but at the same time are a key to the clients' operations.
Valuation
The fact that Buffett is buying into IBM - a first for him buying into traditional tech - is reassuring to me that IBM is likely not near its peak value. Still, it is important to look at the valuations ourselves. IBM does not have a lot of debt. If I subtract the cash on the balance sheet from the long term debt, there is about $30 billion in net long term debt. That does not scare me given IBM also has a fairly steady $20 billion EBITDA and a market cap north of $140 billion. On a enterprise value/Ebitda basis, it is attractively valued at 8x.
Another interesting way to look at IBM is through a FCF lens. IBM spends a predictable amount on CapEx of between 4% and 6% of sales. Shifting gears in the CapEx department is not having much effect on the FCF yield, which is currently near a five-year peak. If you go back 10 years, it has been near 12% but usually it is much lower.
That is not surprising because IBM has managed to grow earnings over the past 10 years at over 9% per year. The top line has shrunk a bit over the last few years due to the sale of non-core assets, but that does not necessarily hurt total shareholder returns. Withdrawing from less profitable businesses is still a smart move. If IBM can slowly return to even half its historical growth rate, picking it up today will turn out to be a profitable investment.
Outlook
IBM is facing a challenge in the trend towards open-standard cloud computing. The company is pivoting to deal with this challenge. It is has kicked up its participation through the Open Power program into the second gear and is actively searching out partnerships with Apple, SAP, Tencent and Twitter. At the same time, IBM has very strong relationships with its customers. It is not a coincidence that the saying (originally a marketing slogan) is:
The largest of global enterprises like to work with firms that can serve them all over the world. Employees are trained using IBM software, which is an additional roadblock when a customer wants to switch. My conclusion is IBM is facing real challenges, but it has a credible plan to overcome them.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
