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IBM: Value Play or Value Trap?

October 25th, 2013 Leave a comment Go to comments

IBM is testing the mettle of its investors right now. This inevitably happens to everyone, something happens to your investment in the market that removes the comforting confirmation of your investing hypothesis. After all, if you buy low, then the market rewards you with a higher share price, this means you are a great investor, right? Not necessarily. Today stocks are going up because, well.., stocks are going up. There doesn’t have to be a reason.

As of now, I don’t have any investment in IBM.

Great investments don’t necessarily get rewarded by the market. This can be a good thing because you get more time to increase your position and get a larger percentage of earnings.  Tobacco stocks have been written off by investors due to ethical concerns and also the misguided notion that these companies products are declining and going away. There is a distinction here: a sales decline for a product is a separate issue compared to whether it’s a good investment. That domestic tobacco producer, Lorillard (LO) just announced a 15% earnings increase for last quarter. Not bad for a dead industry.

 

Today’s Market

In the market we have today, pretty much everything is going up. It makes everyone look like a great stock picker. The market is up so much, almost 25% YTD (including dividends), this means that there are many stocks that are up much more than that.

The water cooler talk of some investment your co-worker bought that went up 40% YTD really isn’t all than impressive. And then we have IBM. It’s down about 33% YTD compared to the market (or about 7% including dividends on its own).

The question is, does IBM currently represent a value play or a value trap at today’s prices? Let’s look at it.

Buffet Is All In

The most famous investor has bought into IBM because he sees this investment as a value play.

Warren Buffet has invested in IBM starting in 2011. This isn’t simply a small stake in his first ever technology company investment, it’s a huge bet that currently is almost 15% of his investment portfolio or the 4th largest position. In his 2011 Berkshire letter to shareholders, he made the case that IBM represents a good investment because IBM made their case with a so-called road-map that details exactly how IBM would perform over the next 5 years. The road-map includes what the company will do in its business as well as exactly how shareholders would profit.

In that shareholder letter, Buffet noted that he wishes that IBM’s stock price would languish so that the share buybacks would increase his earnings share. So far, his wish has come true. IBM is trading near BRK’s average price.

 The Road That Has Passed

In IBM’s Road Map, they also talk about the road that has passed, how the company has performed since the year 2000. Here are the numbers:

Share Repurchase and Dividends: Since 2000, we have returned almost $150 billion to shareholders—paying $26 billion in dividends and reducing the outstanding share count by over 35 percent. We expect to return $70 billion to shareholders in our 2015 Road Map period—$50 billion through gross share repurchases and $20 billion in dividends.

Technology stocks are not usually value investor friendly. In 1992, IBM had quite a large dividend and then cut it down in 1993 significantly to invest in the business. Not exactly value investor friendly. Since then, the company had made it clear that they are offering a plan for the shareholders.

This sounds great, but it was a bad decade to be an IBM investor. In the year 2000, IBM was valued at a P/E of 22, which was the 1990’s Internet Bubble price. It spent the next ten years getting out of its own way. Earnings went up, share buybacks went up but the stock needed to catch up to a lower valuation that reflected its real prospects. Adding it all up, IBM offered only a return of just over 4% per year (dividends reinvested). Not that good.

But that was the past, what about the future?

2015 Road Map

The 2015 Road Map has already begun and it has created some shareholder value. Since 2010, earnings have increased by over $3 per share as shown below:

 

If you bought IBM at the start of the 2015 Road Map, in January 2010 you would have realized an annual return of about 10%/year (dividends reinvested). The earnings growth through this period was about 13%/year, so the stock price has underperformed the actual earnings performance.

The interesting part about this is that the stock was more expensive in 2010 (P/E of 15) than it is now (P/E of 12). This makes sense, if the earnings increase faster than the stock price the valuation must go down. Even so, you still earned a decent return buying IBM in 2010.

If you believe the 2015 earnings number of $20/share, that implies a forward P/E of 8.8. ( This does not include the approximate 4% of return in dividends you will earn over that period). If IBM maintains the same P/E as today, this implies a return of over 40% or about 20%/year (dividends included).

About That Revenue Number

IBM has been criticized recently because it’s revenue hasn’t increased in many quarters. If you review the revenue history of IBM, you will realize that simply looking at the change in the revenue number doesn’t accurately represent what is going on with its revenue.

In a simplistic growth story, revenue growth is very important. No one will pay 80X earnings for a company that doesn’t have big revenue increases going forward. But, it’s clear that IBM isn’t a growth story anymore like, say Salesforce.COM (CRM) or Facebook (FB).

The Road Map makes it pretty clear what is going on: IBM isn’t focused on revenue, it’s focused on margins and free cash flow generation. It goes something like this: if revenue is 100B this year and also 100B next year, but this year you improved your income margin by 1% are you better off? Clearly you are, you put extra $$ in your pocket.

Going after revenue for revenue’s sake doesn’t improve the business if margins go down resulting in less cash flow and subsequently less earnings.  This chart demonstrates their cash flow performance which comes from their focus on margins.

These cash flow numbers are raw, not subject to financial engineering that would occur if indicated in per share numbers. So, the business is becoming more profitable over time.

Conclusion

The conclusion of this analysis has resulted in a different outcome than what I expected. I’ve come around to the idea that IBM may actually represent a good value right now.  IBM has indicated that nothing has changed from their view that they will earn $20/share in 2015. I can see why: the focus on cash flow and buybacks will drive earnings higher.

The Road Map has already provided shareholders good returns. Given that the stock is even cheaper now, one could argue that the returns should be even better in the next few years.

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