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

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:

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.

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