IBM a Crackling Long-Term Buy

 | Oct 09, 2013 | 11:00 AM EDT
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Shares of IBM (IBM) have been beaten up over the last few months: The stock has lost 16% since April. A big name like this is not flying under anyone's radar, so that sustained drop is not without good reason. Indeed, neither earnings nor revenue have been good for IBM lately.

For instance, in the latest earnings report IBM said revenue was down 3% year over year as operating earnings per share declined 8%. The company's biggest losses were in its systems-and-technology segment, with a double-digit year-on-year drop. Perhaps most concerning, revenue in "growth markets" -- effectively, developing nations -- was up a meager 1% vs. the prior year in constant currency.

This wasn't the first quarter of weakness from IBM, so some investors probably see these numbers as an ongoing thing despite the company's "road map" to $20 EPS by 2015. Indeed, some of this softness, particularly in systems and technology, seems to be company-specific and set to persist for the long haul.

However, revenue numbers are not as bad as they may look. In constant currency, revenue was down only 1% year over year. Also, a good bit of the decline is because of charges from "workforce rebalancing," or layoffs. Those cost reductions should start adding to the bottom line in the latter part of the year. Here's one ray of sunshine, as well: The gross margin is up 1.4%.

While earnings do look flat, the big picture looks much better. I believe IBM is on the forefront of some major changes in how we interact with computing. Consider the company's big push towards "cognitive computing." This entails computers interpreting patterns in correlation among many data pieces, and then drawing their own conclusions. Because data is growing exponentially, the traditional method of feeding data to a system will not be effective much longer. Computers must recognize patterns and determine their significance. Cognitive computing is IBM's answer to this.

Other trends, such as cloud computing and IBM's initiative in growth markets, should eventually propel earnings to the road map goal and beyond. Of course, things aren't going so well right now, but IBM has weathered greater challenges than this.

Valuation and Conclusion

At 11.2x earnings, IBM shares are priced well below their historic price-to-earnings ratio of 17.8x. While it is difficult to project where this stock will go right now, so close to its next earnings report, this valuation demonstrates that we could see IBM jump to about $250 and still be at fair value. That could very well be why Warren Buffet has been buying this stock liberally as of late. The stock really is in the bargain bin right now.

But understand a couple of important things before jumping into IBM. First, the systems-and-technology division is facing some steep competition, and it will take a lot to finally turn it around to growth. Second, there are better short- to medium-term deals in tech right now, such as Cisco (CSCO) and Microsoft (MSFT). Both of these pay higher yields with comparable dividend growth.

In the long term, however, IBM's new growth initiatives and excellent acquisition record make that stock worth buying at current levels.

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