Is IBM the Best IT Stock for the Next Decade?

Few fields move as rapidly as technology. Businesses creating outsized profits and returns for shareholders quickly get bull's-eyes on their backs and are targeted by other companies looking to disrupt their products by selling cheaper alternatives that still prove "good enough." Even if a company continues to dominate its particular field, other changes in technology can shift spending away from its products. Think about how Microsoft still dominates PCs, but it's pressured by sales shifting to mobile devices like smartphones and tablets.

With that in mind, today we're looking at how International Business Machines (NYSE: IBM  ) innovates. Technology companies can innovate either through acquisitions or spending more on research and development (R&D). We'll compare IBM's spending in these areas to that of its closest peers and assess whether the company is investing enough in its future.

Research and development
Over the past five years, IBM has spent an average of 5% of revenues on R&D. The table below summarizes how IBM's R&D expenditure relative to revenues compares to some of the company's closest peers:

Company

2006

2007

2008

2009

2010

LTM

IBM 4.6% 4.8% 5.3% 5.6% 5.4% 5.8%
Hewlett-Packard (NYSE: HPQ  ) 3.9% 3.5% 3.0% 2.5% 2.3% 2.5%
Dell (Nasdaq: DELL  ) 0.9% 1.0% 1.1% 1.2% 1.1% 1.1%

Source: Capital IQ, a division of Standard & Poor's. LTM = last 12 months. Dates above are calendar years, while yearly total is for company fiscal years closing in that period.

While IBM's R&D budget has been fairly stagnant in recent year, that's partially a result of revenues that are stagnating. That's not entirely a bad deal; IBM has refocused on higher-margin service and software offerings. In addition, the company has shifted away from lower-margin server sales to focus on emerging areas like blade servers. While that can negatively affect sales, it has also caused IBM's margins to shoot upward. Overall, IBM appears to be spending well on emerging technologies, as I'll describe more below.

Acquisitions
In technology, some of the best companies have turned growth through acquisitions into an art. IBM has adeptly spun off capital-heavy businesses like hard drives and PCs while it focused on acquiring additional services and software expertise that have transformed its business model.

However, on the opposite end of the spectrum, Hewlett-Packard is often criticized for under-investing in research and development to the point that it has to overpay on acquisitions to catch up with competitors.

Investors should remember, most of all, that companies are valued by the cash flow they can bring in for their shareholders over time. If companies need to continue making purchases in perpetuity to keep growing, that amounts to a reduction in cash flows, and investors should treat acquisition spending as a continuing outflow against cash flow. With that in mind, let's take a look at IBM's free cash flow over the past five years against cash spent on acquisitions.

Source: Capital IQ, a division of Standard & Poor's. LTM = last 12 months. Dates above are calendar years, while yearly total is for company fiscal years closing in that period.

While highly acquisitive, IBM's cash flows are still robust even after accounting for acquisitions. More importantly, organic growth isn't significantly different than overall growth since most acquisitions seem to be for companies with higher price-to-sales multiples that IBM feels will plug technology holes. On IBM's 2015 roadmap, acquisitions account for less than 10% of planned earnings growth.

Final thoughts
IBM could be criticized for its lack of investing in R&D, but next to peers it clearly is doing a better job of reinvesting in its core business. IBM CEO Sam Palmisano has critiqued HP's underinvestment, saying that it'll force the company to make acquisitions to catch up in emerging technologies, and that seems to be just what's caused HP to engage in recent acquisitions like its wild bidding war with Dell over 3Par. Overall, of all the technology vendors combining services, software, and hardware, IBM appears the best-positioned to outperform over the next half-decade.

To get up-to-date IBM news and analysis, add the company to your watchlist today:

Eric Bleeker owns shares of no companies listed above. The Motley Fool owns shares of International Business Machines and Microsoft. Motley Fool newsletter services have recommended buying shares of and creating a diagonal call position in Microsoft. 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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