The market in missing an important fact about this Warren Buffett dividend stock
- IBM is at a turning point.
- The market is underestimating the growing importance of the strategic imperatives and growth catalysts that these businesses represent.
- At the current valuation, you get two businesses for the price of one, and some spare change.
- At current prices, IBM is a compelling buy.
In recent years, the share price of IBM has been hammered by negative sentiment. It has fallen from a peak of $215 in 2013 to its current level of $152. I believe the negative sentiment is shifting, and that, at current prices, this stock is an interesting investment. In fact, although the core business of IBM is in decline, the new “strategic imperatives” are growing substantially and will soon represent the majority of the company’s sales.
(IBM stock price; Source: Google Finance)
IBM revenues may be in decline, but the future doesn’t look bleak
Undoubtedly, IBM’s core businesses are suffering and the revenues are declining. Total revenues declined from $92 billion in 2014 to $81 billion in 2015. Although this number is worrisome, most of the decline is due to currency fluctuations and divestitures. Adjusting for these factors, the yearly decline is only 1.2%. Of course, a decline is always bad news, but the trajectory and IBM’s investment in its “strategic imperatives” offer strong future opportunities.
To revamp growth, the company has invested over $30 billion in five key growth areas: Analytics, Cloud, Mobile, Security and Social. These areas offer an incredible potential that is already being captured. Year on year, these segments grew by 17%. In detail, Analytics grew 9%, Cloud 36%, Mobile a staggering 93% and Security 20% (Social is basically flat). Revenues generated by these areas now represent 37.4% of the company’s total revenues (Source: IBM 2015 annual report and Q1 2016). Such growth is impressive, considering that in 2010, strategic imperatives represented only 13% of total revenues. These numbers are more appropriate for a tech start-up than for a giant like IBM.
A bright future
The growing importance of strategic imperatives brings significant hope for the future. These segments are forecast to grow substantially industry-wide. Through Watson, IBM is the market leader in artificial intelligence and big data. Fortune recently argued that “the application of Big Data software algorithms is elevating decision-making precision to a whole new level, creating efficiencies, saving costs or delivering new solutions to important problems.” Many industries and applications are going to be profoundly reshaped by these technologies.
Cloud is also growing rapidly in relevance and market value. Forbes estimates that the cloud market will reach $228 billion by 2026, up from $33 billion in 2015. Similar patterns can be found in the other strategic imperatives. IBM invested heavily in these segments, and the vision of its CEO, Ginni Rometty, is inspiring. Before investing in IBM, I carefully watched a few of her interviews, which gave me a good insight into her attitude and vision for the future of the company. For example, I completely agree with Ms. Rometty that “growth is not a strategy.” Of course it matters, but as a shareholder I care about value creation for my shares. With an ROE of 94%, plenty of value is being created. I also agree that technology is going through a period of profound change. I advise any reader to spend a few minutes watching these videos.
In the next few years, strategic imperatives will represent the majority of IBM’s revenues. According to Zacks, revenues have basically bottomed and will be flat in 2016 and 2017. Assuming core revenues keep declining at a rate of 11%, and strategic imperatives keep growing (at a slower rate than today), I expect revenues to be $82.7 billion in 2020 (compared to the $79 billion forecasted for 2016). By that time, strategic imperatives will represent two-thirds of total revenues. This suggests the company might start to grow again soon.
IBM is a cash-generating machine
Despite declining revenues, the core business is still highly profitable and generates tons of cash. In 2015, IBM had a gross profit margin of 49.8% and generated $13.1 billion of free cash flow ($17 billion from operating activities). This robust free cash flow was generated despite investing 6% of revenues in R&D (IBM is the leading company for patenting activity) and $4 billion in capital expenditures.
The cash generated allows it to remunerate shareholders generously. The company recently increased its dividend from $1.3 to $1.4 per share/quarter. This offers a compelling 3.8% dividend yield. IBM has constantly increased its dividend and has room for further increases. In 2000, the dividend was 0.13, reflecting an increase of 1000% in 16 years (Source: Nasdaq). Considering that in 2015, it spent $5 billion in dividends out of a $13 billion free cash flow, your dividend payments look safe.
The company is also repurchasing a large number of outstanding shares, investing an average of $10 billion a year for the last four years for this purpose. This significantly reduced the number of outstanding shares – from 2007 to 2016, the number of shares has almost halved, from approximately 1.6 billion to 964 million in Q1 2016. Most of the time, share buybacks are a waste of shareholders’ value, but at current valuations, IBM looks to me like a good investment.
Is the valuation of IBM fair?
The valuation of IBM can be conducted in many ways. First, let’s disentangle the strategic imperatives from the core business. In 2016, these segments should reach $33.6 billion. It is uncertain how much of this is profit, but considering their growth rates, it is fair to value them on a price/sales basis. Comparing the company’s strategic imperatives with those of other large growth companies such as Amazon (20% growth y/y) or Microsoft (8% growth), Adobe (17% growth), Alphabet (13% growth) offers an initial valuation metric. The average price/sales ratio for these companies is 5.64. Applying the same sales ratio to IBM’s strategic imperatives, we get a value of $189 billion. Today, IBM’s market cap is $146 billion, so if we use a similar valuation method as applied to other growth stocks, we get the core business for free, and $43 billion of spare change. This is a simple valuation, but it shows how unreasonably valued the company is. As in a supermarket, you get two businesses for the price of one, and some vouchers.
Second, let’s apply three common valuation techniques: abnormal earnings growth, Graham valuation, and residual earnings. I applied a WACC of 6.25% (Source: Gurufocus.com) and a long-term growth of 1%, alongside a required return of 7.5%. Based on these assumptions, I obtain the following valuations:
- Abnormal earnings growth – $253/share
- Residual earnings (capitalized after 2 years) – $237.2
- Residual earnings (capitalized after 5 years) – $212.4
- Graham – $179
- Average – $219
These valuations show that at the current share price of $152, IBM is undervalued. Entering the market now would give an upside potential of 44% from the average valuation, and 17% from the most conservative valuation. (I started writing this article a few days ago, when the price was $145.)
IBM is 105 years old. The company has been through numerous ups and downs, survived many crises, and thrived. I believe that although IBM is going through tough times, its vision is inspiring and the direction taken correct. The market is underestimating the growing importance of the strategic imperatives and the growth catalysts that these businesses represent. These initiatives are starting to pay off, and will reward shareholders in the coming years. The strategic imperatives are growing robustly, the company returns large sums of cash to shareholders through dividends and buybacks, and its top line will soon start to grow again. At current prices, IBM is a compelling buy.
Disclosure: I am/we are long IBM.
Categories: International Stocks & Other