Why I Bought IBM Stock After Its Big Slump

International Business Machines (IBM 0.16%) has been on my watch list for quite some time, and I used the collapse in the stock price following the company's disappointing third-quarter earnings report earlier this month to finally open a position. Shares of IBM have plummeted about 11% since the company came up short of expectations, a big move for a blue chip stock, and the current price of right around $160 per share is the lowest it's been since 2011.

IBM data by YCharts

While the results seem to suggest that IBM is in serious trouble, IBM remains a wildly profitable company with a wide, durable economic moat. The core of IBM's business remains strong, and while earnings growth may be hard to come by in the short term, especially as IBM invests heavily in new initiatives, investors buying at this price are getting a great deal.

A look at the results
IBM has been around for more than 100 years, and the results of a single quarter are largely meaningless in the grand scheme of things. Regardless, here's a summary of some of the Q3 numbers that have caused all of the doom-and-gloom talk surrounding IBM:

Source: IBM.  

Certainly, the quarter wasn't a good one. Net income declined by nearly 20%, and the company's share buybacks couldn't erase a decline of that magnitude. Services and software declined slightly, and hardware continued falling sharply, as it has been doing for quite some time.

What it all means
These numbers aren't great, but they also aren't cataclysmic. IBM has hit a speed bump, not a wall, with lower productivity in the services business as the main culprit. Revenue has now declined or remained flat for 10 quarters in a row, but IBM is not a company that attempts to grow revenue at any cost. Over the past decade, revenue has been essentially flat as IBM has exited low-margin business, instead focusing on increasing profitability.

IBM Revenue (Annual) data by YCharts

IBM has recently sold off its x86 server business to Lenovo, a good move since the vast majority of x86 servers are powered by Intel chips, and differentiation is difficult. IBM also got rid of its chip foundry business, paying GlobalFoundries $1.5 billion to take the money pit off its hands. IBM will now use GlobalFoundries to manufacture chips for its remaining servers, including Power Systems and System z, IBM's mainframe business.

The mainframe business is at the heart of IBM's economic moat. Mainframes are extremely good at processing an enormous amount of data in a reliable and safe way, and industries such as banking continue to heavily rely on IBM's mainframe computers. Switching costs are extremely high, and in many cases there are simply no good alternatives to mainframe computers.

While IBM derives little of its revenue from the direct sale of mainframes, an analyst at Sanford C Bernstein estimated in 2012 that all of the mainframe-related products, including software and services, accounted for 25% of IBM's revenue and more than 40% of its profits. The mainframe is the foundation of IBM's business, and that foundation remains strong.

Mainframe hardware revenue declined by 35% year over year in the third quarter, but mainframe sales follow a predictable pattern, with a jump in sales when a new model is released, followed by a subsequent collapse. It's been nine quarters since the beginning of the current mainframe product cycle, and the revenue declines are right in line with expectations.

IBM has a history of adapting to change, exiting unattractive businesses and investing in new ones. While the next few years certainly won't be a smooth ride for investors, with IBM now trading at less than 10 times expected earnings for this year, there is a significant margin of safety built into the stock price. IBM still generates in excess of $16 billion per year in net income, and it has the ability to easily buy back 5% of its shares annually while still paying a solid dividend and investing in the future. IBM recently invested $1 billion in Watson, its natural-language system, and an additional $3 billion on pushing chip technology down to 7nm, possibly utilizing new materials beyond silicon. To claim that IBM is simply old-tech, unable to innovate, would be to ignore the billions that IBM spends every year researching new technologies.

Foolish thoughts
IBM doesn't appear to be in serious trouble. The world is changing, and IBM will undoubtedly change with it, and while short-term results may be pressured, IBM is far from dead. Tech companies such as Apple may seem more exciting, with hundreds of millions of people around the world every day directly using its products. But every time you swipe a Visa card, or make an online banking transaction, you're indirectly using an IBM mainframe. Long story short; IBM is a bargain at $160 per share.