IBM Looks Very Attractive

 | Sep 07, 2013 | 4:00 PM EDT
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IBM's (IBM) stock price has been a big disappointment for investors in 2013. The shares are down close to 5% for 2013 vs. the 16%-plus rally in the S&P 500. But, in all fairness, the broader large-cap tech index has struggled in 2013 with minimal year-to-date gains.

A large part of this disappointment is related to macroeconomic weakness emanating from Europe and various emerging markets, including China and Brazil. Business is just plain soft. Unfortunately, the company was also negatively impacted by a mix-of-business shift away from sales of high-margin, proprietary UNIX servers and software platforms, and toward lower-margin, industry-standard servers and cloud-based software packages.  

As a result, in the most recent quarter, management embarked on another round of workforce rebalancing actions that should add $1 billion to the bottom line. The company is also exploring options to exit the server business as it engages in high-level talks with Lenovo, although no actions have come to fruition to date. 

Given these events, we believe investors should look afresh at IBM at current levels. The company has a very large and stable services-and-proprietary-software portfolio that generates more than 80% of IBM's $17 billion in annual net income. It would be difficult, if not impossible, for competitors to migrate these large books of contracts and software platforms to competing product lines.

We expect management, in all likelihood, to take additional actions to further rebalance the franchise toward more services and proprietary software by means of select software and service acquisitions. IBM recently acquired two niche software providers in security for a little over $1 billion. We expect these accretive tuck-in acquisitions to continue. We would also expect IBM to exit the slower-growing and lower-margin hardware divisions in order to improve operating performance. 

Additionally, we expect management to reward shareholders through its aggressive share-buyback programs. Since 2005, stock-repurchasing has accounted for more than 40% of IBM's per-share earnings growth.  Management expects to buy back another $30 billion in stock from 2013 through 2015, for a 15% reduction in the share base from current levels. There is also a potential for this program to be enlarged. CEO Virginia Rometty is committed to hitting the $20 EPS target in 2015, even if this requires larger share buybacks. The company can afford these measures thanks to its strong AA credit rating at Standard & Poor's.

IBM's shares currently trade at 11x the 2013 EPS estimate of $16.90, and at 10x times the 2014 estimate of $18.65. That's a very favorable valuation relative to the S&P 500's 14.5x earnings. Going forward, we expect the company to report 8%-to-11% earnings growth per year, a much higher earnings growth rate than that of the S&P 500 overall. IBM also has a respectable 2% dividend yield, and a below-market 0.9 beta. 

We like IBM and believe investors would be taking very little risk purchasing the shares at current valuation levels. There is also a strong likelihood that management will take more drastic actions if the share price continues to stagnate in the coming year. This could include a more aggressive cost-reduction program and more aggressive dividend and share-buyback programs to enhance shareholder value, as well.

All the levers the company is prepared to pull in the upcoming year should result in a higher stock price from current levels.



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