DRIP Portfolio Candidate: IBM

This week, Fool analysts Todd Wenning and Bryan Hinmon are presenting two stock ideas for inclusion in the Fool DRIP Portfolio. Technology stocks are on the docket today with Bryan presenting IBM and Todd making a case for Microsoft (Nasdaq: MSFT  ) .

It's hard for us lay-folk to comprehend, but having too much cash can be a problem. For example, infamous former TYCO CEO Dennis Kozlowski splurged on a $6,000 shower curtain, only to be one-upped by Enron's corporate art purchase of a $590,000 vinyl light switch sculpture. Throw in the pressures of quarterly corporate performance, and companies are often paralyzed into inaction or feel the need to just do something, even if it's not prudent.

Over the past decade, IBM (NYSE: IBM  ) has generated $80 billion in free cash flow and has followed a productive plan for each dollar. I expect the company to generate an additional $100 billion over the next decade, and I like the company's plan for its uses. Here's a hint: Shareholders will get a rising dividend to reinvest in a declining share-base; it's a DRIP investors dream come true.

Corporate Play-Doh with brains
IBM has had a remarkable history. From its early days manufacturing scales and coffee grinders, to its foray into business machines and eventually mainframes and personal computers, IBM has not been afraid to alter its course. The company's willingness to keep its eyes forward, remold its business, and be successful in new ventures has kept it alive and enabled it to become the $161 billion tech bellwether it is today.

Early on, IBM realized that to have the flexibility to shift as nimbly as Barry Sanders, it needed to fill its ranks with the smartest people in the world. Think Google (Nasdaq: GOOG  ) has the clout for attracting the best and brightest? Well, IBM has the largest math department in the private sector, has been the leading U.S. patent generator for 17 years straight and has produced five Nobel Prize winners. Not too shabby for a company that used to make coffee grinders.

All of this matters because the tech landscape can change quickly. Most recently, IBM shed its personal computing division and scaled back its commodity hardware exposure. Top brass has focused investment and effort on building world-class consulting and software solutions. As a result, less than 10% of IBM's profits comes from hardware nowadays and 50% of its revenue is recurring. Not only is this revenue of higher quality and more reliable than hardware sales, but check out what it has done to margins and profitability:

Metric

2005

2006

2007

2008

2009

EBIT margin

13.1%

14%

14.7%

17.2%

19.5%

Net margin

8.7%

10.4%

10.5%

11.9%

14%

FCF margin

9.6%

9.7%

6.3%

11%

14.8%

Return on Capital

13.5%

15%

15.7%

20.1%

24.2%

Source: Capital IQ (a division of Standard and Poor's).

I mentioned that IBM has followed a plan for utilizing all this cash: Big Blue has raised its dividend for 14 consecutive years, reduced its share count by 25% since the end of 2000, and spends $5 billion per year on research and development.

Imitation is the sincerest form of flattery
So what could keep IBM from taking over the world? Well, because IBM is so large, it competes across the entire tech landscape and therefore faces competition from all angles. Additionally, some investors point out the company's slow revenue growth as a sign that it is simply too big.

Two factors play into IBM's dominant competitive advantage. First, its reputation, reliability and breadth of services are an easy sell to CTOs of large companies. IBM can do it all -- and if it can't, it will develop or buy the ability to (IBM has spent $161 billion on R&D, capital expenditures and acquisitions in the past 10 years). IBM's hold on the IT Solutions market isn't guaranteed, though. Two of its closest competitors are trying their best to walk, talk and dress like IBM. With Hewlett-Packard's (NYSE: HPQ  ) acquisition of EDS and DELL's (Nasdaq: DELL  ) acquisition of Perot Systems, IBM's solution-oriented approach is now less unique.

While the company's end markets are collectively growing at low single-digit rates, IBM has been able to expand its earnings per share by an annual rate of 18% over the past five years. This financial wizardry may make you think Harry Potter has taken over duties as CFO, but the explanation is far less magical. The combination of a higher margin business mix (services vs. hardware), cost cutting and share repurchases (to the tune of around $80 billion in the past 10 years) have done wonders. Of course, bears say margins can't increase forever and issuing debt to repurchase shares isn't a sustainable or high-quality way to grow the bottom line. I am reassured, though, by the fact that free cash flow has consistently approximated net income.

Valuation
Any way you slice it IBM looks cheap. Shares are trading at 12 times earnings, 12 times levered free cash flow and sport an enterprise value-to-EBITDA multiple of just over seven. Management expects to double earnings per share over the next five years, implying growth of nearly 15% per annum. Performing a discounted cash flow analysis with 3.7% compound annual revenue growth, assuming declining margins and a 9% cost of capital, IBM is 10% undervalued. Tweaks my reinvestment and sales growth assumptions indicate that there is substantial upside too.

Foolish bottom line
If you think, as I do, that IBM can continue to stay ahead of the tech curve and reinvent its business, then buying near today's prices is a good entry point into the stock. With what seems to be a dirt cheap valuation in this highly profitable, financially strong technology titan, it makes for a great first stock for the DRIP portfolio.

So what do you think? IBM or Microsoft? Please post your vote below.

Previous DRIP Portfolio Articles:

Fool analyst Bryan Hinmon does not own shares of any company mentioned. Microsoft is a Motley Fool Inside Value recommendation. Google is a Motley Fool Rule Breakers choice. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Google. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.


Read/Post Comments (3) | Recommend This Article (24)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 26, 2010, at 7:11 PM, MMTInvestor wrote:

    IBM hands down.

  • Report this Comment On July 26, 2010, at 9:33 PM, FutureMonkey wrote:

    Inspite of Todd's excellent use of reference to Michael Bolton's fight with the fax machine in the movie Office Space (P.C. Load Letter), I'm going to have to back IBM as the dream tech DRIP for the coming decade. While I believe MSFT is also a good investment, if I could have only one stock and disappear to a desert island for 25 years, I'd go with IBM over Microsoft.

  • Report this Comment On July 27, 2010, at 11:00 AM, rdtuck02 wrote:

    I would just mention pretty much the same thing I did on the MSFT article: IBM charges $1 ongoing investment fee and 2% div re-investment up to $3. Not even calculating re-investment fees, investing the min amount each month equates to 2% service fee. Plus it's a true DRIP rather than a DSPP, making entry slightly more difficult. The fees probably don't matter for investors making large contributions, but can cause a drag on returns for the small-time investor making min monthly contributions

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