IBM Is Well-Positioned for the New New Economy

Investors looking for a stock for the next five years ought to do two things. First, read This Time Is Different: Eight Centuries of Financial Folly by Harvard's Kenneth Rogoff and University of Maryland's Carmen Reinhart. Second, buy IBM (NYSE: IBM  ) stock.

Seven lean years
This Time Is Different started as an academic study of financial crises. Read it when you have insomnia. If the academic-speak doesn't put you to sleep, the conclusions will scare you awake. Key takeaways: Developed economies are in for an extended period of slow growth -- the investing equivalent of seven lean years -- and inflationary strategies are the easiest fix for politicians to pursue.

Are Professors Reinhart and Rogoff credible? You decide. Their study is now a best-selling book in Amazon's "business and investing" category. Global leaders have asked for, and received, their advice.

Investing for stagflation
With the good professors' work suggesting developed countries' economic growth will be subpar though the middle of this decade and inflation will rear its ugly head before then, what's an investor to do, put all his or her stock eggs in the emerging markets basket?

Uh, no. Go ahead and put some eggs in emerging markets. Then invest in companies that can grow revenue in a lackluster economy while containing costs in an inflationary environment. With margins near record highs and commodity prices on a tear, that's easier said than done. This is where IBM comes in.

IBM is positioned to thrive. In May, management presented a plan to grow earnings per share at a compound annualized rate of at least 12% through 2015, with potential for upside.

Maybe they're not clued in to the "seven lean years" outlook, you say. That's unlikely. IBM's scary smart management has a periscopic-like ability to see over the horizon. That keeps them conservative in setting expectations.

It also helps IBM skate to and influence where the puck will be. 

The tortoise and the hare
How does a technology Goliath with $98 billion in sales and roots dating back to the early 1900s deliver 12% or better EPS growth? IBM's five-year plan assumes:

  • Base revenue growth of only 2% annually.
  • Total revenue growth of about 5% annually, helped by future acquisitions and four growth initiatives that have already boosted growth: cloud computing, growth markets (e.g., BRIC countries), business analytics, and smarter planet.
  • Annualized EPS growth of about than 3% from productivity gains.
  • Annualized EPS growth of 1% from a shift to higher value products and services.
  • Annualized EPS growth of about 4.5% from share repurchases.

Nice plan, but can IBM execute on it? Consider that it would be a slowdown from recent results. With less than a quarter to go, IBM is on track to grow EPS at a 17% annualized rate from 2006 through 2010. The company has delivered 31 consecutive quarters of year-over-year EPS growth. (Yes, right through the financial crisis.)

Buy low
Of course, you still have to make sure you're getting a fair price for any stock. Luckily for IBM investors, IBM's valuation is attractive. The stock has a P/E ratio of 13.3 times, well below the S&P 500 index's. IBM delivers quality earnings, too. Wall Street likes to focus on operating EPS -- aka "earnings before bad stuff." IBM's operating EPS is a measly one-third of one percent above reported EPS. That compares to a whopping 10% for the S&P 500 index. Here is what operating EPS does to P/E ratios:

 

IBM

S&P 500 Index

Operating P/E (earnings before bad stuff) 13.3 times 15.9 times
Reported P/E 13.3 times 17.5 times

As of Dec. 27 close.

IBM has a 1.8% dividend yield, slightly below the S&P 500's 1.9%. IBM's annual dividend has more than doubled over the last four years, from a quarterly $0.30 to $0.65 per share. Double-digit EPS growth would support continued dividend increases.

IBM's valuation compares favorably with competitors', even when using distorted operating P/Es (see below). Challenged Dell (Nasdaq: DELL  ) trades for a similar P/E ratio but offers no dividend. Hewlett-Packard (NYSE: HPQ  ) , which lost its star CEO in August, trades at a more modest P/E ratio with a less attractive dividend. Storage competitors EMC (NYSE: EMC  ) and NetApp (Nasdaq: NTAP  ) specialize in a high-growth market segment -- and it shows in their premium P/E ratios. Oracle (Nasdaq: ORCL  ) also trades at a premium P/E ratio and offers a more meager dividend.

 

Operating P/E

Dividend Yield

Dell 13.3 times N/A
IBM 13.3 times 1.8%
Hewlett-Packard 11.3 times 0.8%
EMC 29.5 times N/A
NetApp 36.5 times N/A
Oracle 23.5 times 0.6%

Many companies are waiting for the economy to improve. IBM has a credible plan to deliver EPS growth of 12% or more despite a tough environment. Stick that in your portfolio for seven lean years.

Fool contributor Cindy Johnson avoided IBM stock on the way down in the early 1990s and bought it on the way up in the mid-1990s. She does not currently own shares in any of the companies in this story. Amazon.com is a Motley Fool Stock Advisor choice. The Fool owns shares of International Business Machines and Oracle. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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