The Bluest Blue Chip

In investing, blue chips are the blue bloods of the market. They're old, rich, and have delivered extraordinary returns for decades on end. Think of firms such General Electric (NYSE: GE  ) , ExxonMobil, and Citigroup (NYSE: C  ) . Just look at what they've done for shareholders over time. And yet none of these firms holds the same promise today as the Computing-Tabulating-Recording Company, which traces its history as far back as 1888, when Dr. Alexander Dey invented the first dial recorder.

Officially, C-T-R was incorporated in New York 95 years ago. Since then, it has produced punch cards, calculators, typewriters, war machines, and giant blue mainframe computers. Today, of course, we know C-T-R by a different acronym, IBM (NYSE: IBM  ) .

Decline of the machines
IBM as we know it began in 1914, when Tom Watson Sr. left NCR (NYSE: NCR  ) -- then known as National Cash Register Company -- to join C-T-R. Within 11 months, he had become president of the company. His zeal for business was immediately felt. According to the book 50 Companies That Changed the World, by Howard Rothman, Watson tripled sales to $15 million by 1920.

The next two decades under Watson's leadership would be just as profitable. So much so, Rothman writes, that IBM continued rolling out calculating machines during the Great Depression. By 1970, "Big Blue" would employ 270,000 workers.

But growth finally peaked in 1986, Rothman writes. Mainframe sales had stalled, and Microsoft (Nasdaq: MSFT  ) had emerged as the king of computer operating systems. And IBM was in steep decline. From January of 1986 to October 1992, its stock, once a dependable grower, plunged nearly 50%. The S&P 500 was up more than 140% over the same period.

Big Blue back in green fields
Management would respond by hiring Lou Gerstner as CEO. Deep cost cuts ensued, followed by an emphasis on identifying and capitalizing on customer needs. Today, IBM has a services arm that does $40 billion in annual revenue -- and is increasingly challenging Accenture (NYSE: ACN  ) and BearingPoint (NYSE: BE  ) .

Yet more work remains. IBM is in the midst of a transformation across all of its business lines, which includes everything from email software to disk drives to servers to consulting. According to a 2005 BusinessWeek cover story, CEO Samuel J. Palmisano, who built IBM's services team under Gerstner, envisions a firm capable of handling large-scale business functions.

Sound crazy? Well, researcher IDC says business process outsourcing, a $442 billion market in 2005, will grow to $641 billion by 2009. IBM should be able to take advantage; its global workforce of 340,000 includes both business experts and brilliant researchers. Plus, Big Blue is a global leader in patents -- it has earned more patents than any other American business for 13 years running -- and sports a well-funded venture capital arm. If there's any firm capable of bringing diverse resources to bear on a business problem, it's IBM.

Give your portfolio some color
Against this backdrop is a stock that appears to trade on the cheap. My rough discounted cash flow analysis suggests that IBM is worth at least $89 a stub. That assumes a 12% required rate of return and that Big Blue will manage only 5.3% growth for the next 10 years and 2% per year ad infinitum.

But that may be a conservative estimate. Consider: If IBM grows normalized earnings by 10.5% annually over the next five years, as analysts predict, net income will blossom to $8.24 a stub. Multiplying that by the services industry's average P/E of 19 equals $156 a share.

Surprised? Don't be. There are a number of blue chips on the market that look remarkably cheap at current prices. After all, large caps have been losing out to small caps for a number of years in a row now. But remember, these are the blue bloods of the market. And they're looking cheap. You'd be looking a gift horse in the mouth not to consider adding a few to your portfolio.

So if you're interested in some more blue-chip bargain ideas, let me suggest our second-annual blue-chip report, 10 Monster Stocks to Anchor Your Portfolio. It's loaded with 10 stock ideas that, thanks to a choppy market, are as cheap now as when we first debuted the report. Click here to get your copy.

Fool contributor Tim Beyers has owned two IBM PCs in the past. Today, he prefers his Mac. Tim didn't own shares in any of the companies mentioned in this story at the time of publication. You can find out what else is in his portfolio by checking Tim's Fool profile. Both Accenture and Microsoft are Motley Fool Inside Value selections. The Motley Fool has an ironclad disclosure policy.


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