Today's Buy Opportunity: IBM

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"11 O'Clock Stock" is going big (blue), and by big I mean more than 400,000 employees, a global footprint, and nearly $100 billion in yearly revenue. While it's not exactly a gem hidden in the rough, today's pick, IBM (NYSE: IBM  ) , makes a nice fit in almost any investor's portfolio.

Fast facts on IBM

Market Capitalization

$160.9 billion

Industry

All things IT

Revenue (TTM)

$97.4 billion

Earnings (TTM)

$14.0 billion

Dividend Yield

2.0%

Source: Capital IQ, a division of Standard & Poor's. TTM is trailing 12 months.

There's a unique opportunity right now in large-cap technology stocks. The sector has rebounded nicely over the past 12 months, with large technology companies posting record earnings. Yet these large, high-quality companies are trading at their lowest valuations in decades.

The disconnect is hard to explain, but it hasn't gone unnoticed. Legendary investor Jeremy Grantham forecasts that large, high-quality companies will outperform small caps by 6.2 percentage points annually over the next seven years. Bill Miller calls IBM "the most remarkably mispriced name in the market," and predicts the company is 30%-50% underpriced.

IBM's drawing attention, but is it alone among its high-tech peers? For comparison, here's a list of how some other technology giants stack up:

Company

Forward P/E (NTM)

5-Year Earnings Growth Rate (Annual)

IBM

10.8

13.0%

Microsoft (Nasdaq: MSFT  )

10.3

8.9%

Intel (Nasdaq: INTC  )

9.8

2.8%

Hewlett-Packard (NYSE: HPQ  )

8.3

23.0%

Oracle (Nasdaq: ORCL  )

12.0

16.3%

Cisco (Nasdaq: CSCO  )

12.2

6.2%

Source: Capital IQ, a division of Standard & Poor's. NTM = next 12 months.

Despite financial difficulties in 2008 and 2009, all the above companies have had respectable growth rates over the past five years. Also, in spite of their size, they've been able to continue growing. Better yet, the growth isn't expected to stop. In IBM's case, the company is targeting nearly doubling profits (more on this later) by 2015. Do these companies, all with established brands and leadership in their respective fields, deserve to trade at valuations this far below the general market?

I don't think so. Well, at least not as far below the market as they are now. Quite frankly, I think almost all of these companies look attractive at today's prices. However, here are a few reasons why IBM gets today's top billing.

1. Underappreciated competitive advantage
IBM's business model is effective. In fact, it's so effective that we're now seeing Oracle, HP, and Dell, all taking steps to copy it. Ah, imitation, the sincerest form of flattery! The beauty of the model comes from two dimensions. First, IBM is able to gain revenue from each phase of managing an IT department. It sells the hardware to companies, then layers on the higher-margin software, and finally it provides services for maintaining the datacenter. Second, once IBM is working with a company and has IBM's products at the core of the datacenter, it's hard to switch vendors.

The model isn't anything new, but it's something that IBM has always been on the forefront of, and it has always had an unparalleled breadth of offerings. While some might point to increased competition from the above companies as well as services competitors like Accenture (NYSE: ACN  ) , the trend actually favors larger companies. Remember, while investors sometimes like to imagine investing as a blood sport with defined winners and losers, a trend can sometimes lift all boats. If big technology firms like HP, IBM, and Oracle are able to increasingly bundle their hardware, software, and services, the trend could favor larger firms to the detriment of smaller companies offering more specialized services.

2. Leverage the balance sheet: shareholder-friendly management
One of the first things investors notice about Big Blue is that it carries some debt, while most of its large technology peers have piles of cash. Some might see this as a negative, however I take the contrarian viewpoint. The way IBM flexes its balance sheet is a key strength.

First off, the company not only pays a 2% dividend, but also aggressively buys back shares. Once factoring in share repurchases, IBM has an impressive 6.5% net payout yield. In the past four years alone, beyond boosting its dividend 70%, IBM has reduced shares outstanding by nearly 14%. Second, Big Blue uses a growth-through-acquisition strategy extremely effectively. Did you notice that IBM sat out the recent bidding war over 3Par that eventually saw HP pay a 240% premium over its pre-acquisition trading price? It's not that IBM lacks a storage unit that could have used 3Par; instead, IBM's management is more disciplined in growing the company. IBM prefers bolt-on acquisitions, especially in software, that it can quickly integrate into its existing offerings.

That's important because you can never quite trust the cash on a technology company's balance sheet. All too often, instead of returning cash to shareholders, technology companies will overpay to acquire smaller firms in tangential "growth" fields. However, with IBM you get a management team with a history of returning money to shareholders, and one with an established, consistent record of smart acquisitions. Best of all, the debt comes at little cost. IBM recently sold three-year debt at a 1% interest rate.

3. An achievable road map for growth
IBM spent the past decade transforming itself. The end result has been a shift into higher-margin areas. Just look at the constant northern march of the company's operating margins:

By 2015, IBM plans to have utilized this margin expansion into generating an additional $100 billion in free cash flow. With all this cash flow, the company plans to repurchase $50 billion worth of its shares, pay $20 billion in dividends, and make $20 billion in acquisitions. It's an ambitious goal, but the company's management has delivered on strong gains throughout the previous decade, which grants them some level of confidence.

In the end, IBM's plans to grow earnings per share to $20 by 2015 (about a 12% annual growth rate) rely about one-third on share repurchases, one-third on productivity gains, and one-third on modest revenue growth. Even if IBM sees only 9% growth in its earnings per share, instead of its targeted 12%, the company would still be seeing about $17.46 per share in earnings by the end of 2015. If the company traded down to a P/E multiple of 10 during that time, investors would still be looking at a 37% share price gain, which doesn't include the continued dividend payments to boot.

No matter how you slice it, IBM looks like a pretty safe play with decent upside.

Bottom line and risks
While IBM has managed to grow its bottom line at impressive rates, revenues stayed pretty much flat. That's partially the result of IBM shifting out of lower-margin businesses, but it's still troubling nonetheless. Also, the company's highly acquisitive nature can make analyzing organic growth difficult.

Finally, IBM still derives a lot of its revenue from mainframe computers that are under assault from new computing technologies like virtualization. While IBM stands to gain some from virtualization, such as through its leadership in areas like private cloud computing, sudden loss of mainframe sales would hurt IBM more than it has to gain from rapidly evolving cloud-computing trends.

In the end, though, the positives look to outweigh the negatives. IBM's too big to resoundingly thump the market like some of its smaller peers, but I think investors getting in right now have a great opportunity for low-risk, market-beating returns.

IBM sure ain't sexy, but it'll get the job done.

Previous recommendations:

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The Motley Fool will wait at least 24 hours after this publication before buying shares of IBM. To see an FAQ on "11 O'Clock Stock," click here.

True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool has a disclosure policy.

Eric Bleeker owns shares of Cisco. Accenture, Intel, and Microsoft are Motley Fool Inside Value recommendations. The Fool has written calls (bull call spread) on Cisco Systems. The Fool owns shares of and has written puts on Intel. Motley Fool Options has recommended buying calls on Intel. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Oracle. Try any of our Foolish newsletter services free for 30 days.


Read/Post Comments (17) | Recommend This Article (33)

Comments from our Foolish Readers

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 September 07, 2010, at 1:01 PM, TMFRhino wrote:

    Hey everyone,

    I wrote up this piece on IBM and could answer any questions. While the basic idea here is to get some "skin in the game" with at least one of these big tech firms, there's a lot to like about IBM itself.

    Best,

    Eric Bleeker (TMFRhino)

  • Report this Comment On September 07, 2010, at 1:24 PM, valari25 wrote:

    It would be easier to ask questions and be critical of your pitch for IBM if it wasn't well presented, well written and incredibly thorough.

    Good job!

  • Report this Comment On September 07, 2010, at 1:50 PM, scanlin wrote:

    IBM also makes a good buy-write candidate for the Sep expiration. The Sep 125s (in the money about 1.5 points as of this writing) yield > 26% annualized if stock is flat to Sep 18 expiration. No earnings risk prior to Sep expiration.

    MikeS

    http://www.borntosell.com

  • Report this Comment On September 07, 2010, at 4:09 PM, fightinag04 wrote:

    First of all, I thought the article was incredibly well written and thorough as well. It was definitely food for thought for a solid stock to be the anchor of my portfolio.

    One question I had (which could be asked about any company really), is about the increase in operating margins partially at the expense of employees. I know several people that work for IBM who have watched benefits and jobs disappear at the expense of growing profit per share and are increasingly frustrated to the point of leaving when the job market improves. When compared to other tech companies like Google, Cisco, etc. who are known for how well they treat their employees, do you think this could in any way effect their ability to grow as projected? What role does employee morale play in determing how well a successful company does?

    Thank you again and fool on!

    Chris

  • Report this Comment On September 07, 2010, at 5:32 PM, TMFRhino wrote:

    Chris,

    Thanks for the compliments on the article.

    Definitely can't discount this. IBM has cut in this regard. They're not as bad an offender as HP, which has cut its R&D to half the level of IBM.

    Morale definitely does have an effect, but its within a balancing act.You need to consider that some employees would leave regardless - Microsoft notoriously never laid employees off (well, until recently), pays well, and spends up to $9 billion a year on R&D, but still loses company's to smaller "up and coming" growth companies like Google, regardless. In the coming years, Google will start shedding talent too. Sunrise, sunset. Also, is a number of losses acceptable to nearly double profits?

    So what's the appropriate level of losses for a mature tech firm? Difficult question to answer. I think IBM should still be pretty successful reaching its road-map because management has excellent planning in this regard, and because IBM's put itself in the right strategic direction. When everyone's trying to copy you and you already have established relationships, that an enviable position.

    Sorry for answering the question with more question :). It's a great debate, and one that I can't really answer. Given the middling outlook for the economy, the risk is somewhat mitigated for awhile. However, it does present a long-term threat if the company sees some brain drain.

    If any former (or current... you can go confidential :)) IBM employees want to leave their thoughts, it'd be appreciated.

    Best,

    Eric Bleeker (TMFRhino)

  • Report this Comment On September 07, 2010, at 6:04 PM, TMFRhino wrote:

    I'd typed up a pretty long response for ya Chris, but it appears to have gone into the ether... I'll give it a bit to show and if it doesn't I'll respond again later.

  • Report this Comment On September 07, 2010, at 6:04 PM, TMFRhino wrote:

    Oh great, of course it shows up the second I throw another comment on :).

  • Report this Comment On September 08, 2010, at 6:14 AM, fightinag04 wrote:

    It happens to the best of us. If anything, it'll help you get another big star for so many posts.

    Thanks for your response. I guess the internal picture is different than the external picture, and "scuttlebutt" refers more to business opportunities, which there is no shortage of at IBM. At the end of the day, the responsibility is to the shareholders, some of which are employees, which means every decision they make is a calculated risk to some point or another. That's why management gets the big bucks.

  • Report this Comment On September 08, 2010, at 1:57 PM, take2bank wrote:

    If anyone just watched the video from "The Big Short" (coming soon), IBM is a "ticking time bomb".

  • Report this Comment On September 08, 2010, at 5:14 PM, CardFanNC wrote:

    I came to your presentation just after watching the "Big Short" video in which IBM was characterized as being a "ticking time bomb" in your portfolio. John Del Vecchio's analysis suggests that IBM misrepresents earnings and that is not likely to grow in the future at the expected rate. You, as he, mention that one risk is the difficulty of accurately analyzing IBM's organic growth. I have been interested in buying IBM but the video has caused me to pause. What do you think about this differing analysis of IBM?

  • Report this Comment On September 08, 2010, at 7:45 PM, TMFRhino wrote:

    If anyone wants to link the video I'd be happy to watch it.

    Part of the issue is... Even if I strip away earnings and grow IBM at half the rate they give guidance toward, the stock's still not exactly priced unattractively. Since growth is about 1/3 an attributor to the roadmap, that doesn't strike me as a "ticking time bomb," it just might mean the company underperforms its high tech peers a bit.

    Again though, I'd watch the video. I worked at an engineering company that grew through acquisition for over 10 years and did it phenomally well. They operated somewhat like IBM, acquisitions which could immediately be packeged in to the core offerings. Not to say some accounting chicanery might not be afoot, but IBM has proven adept at this for awhile.

    Final point, since 2006 the company has made $9 billion in acquisitions. That's the same size of acquisitions that Intel has made in the last MONTH. So, $9 billion in acquisitions in 5 years for a $160 billion company. I'm just saying... Their acquisitive streak isn't THAT much of an extreme. They buy smaller, they buy smarter.

    Best,

    Eric Bleeker (TMFRhino)

  • Report this Comment On September 08, 2010, at 8:22 PM, take2bank wrote:
  • Report this Comment On September 10, 2010, at 3:02 PM, jsnodgrass wrote:

    TMF has, for the nine years I've been a fan, always, and without expception, warned that any shennanigans in regard to financial reporting is a major red flag and alone a good reason to sell. If IBM has been misrepresenting earnings why would anyone buy it as opposed to one of several other big tech stocks that seem to be reporting more honestly?

  • Report this Comment On September 10, 2010, at 3:21 PM, EDJMCPS wrote:

    Ok now I am confused; Here it is a buy but on the Big Short E-Mail it came up as a company to short .

    ED S

  • Report this Comment On September 10, 2010, at 4:28 PM, TMFRhino wrote:

    jsnodgrass,

    I don't think anyone has really accused IBM of shenanigans. They've been very up front about their share buy back policy and the size, their acquisitions have been below other peers, and cash flow is in line with earnings.

    The broader idea (from the Big Short video) is that they'll be unable to continue their growth rates. That's different than not reporting honestly.

    Ed S,

    There's a variety of opinions here at the company. If you subscribe to and follow The Big Short, Mr. Del Vecchio might not prefer IBM. In fact, there might be other TMF picks he's in disagreement with.

    Best

    Eric Bleeker (TMFRhino)

  • Report this Comment On September 10, 2010, at 5:14 PM, jsnodgrass wrote:

    Eric,

    Listen to the Del Vecchio tape again. His exact words were "massaging earnings" and "accounting shenanigans" in direct reference to IBM. If true, IBM is intentionally misleading shareholders--at the very least.

    I would appreciate Mr. Del Vecchio chimming in here.

    John

  • Report this Comment On September 22, 2010, at 4:27 PM, PeeyushFool wrote:

    This is the first time ever that I have seen two Fool services contradicting each other. Please do take this as an opportunity to sync up TMF team on their research.

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