Tech companies Microsoft (NASDAQ:MSFT) and International Business Machines (NYSE:IBM) have a few things in common. Both rose to prominence in past generations. Both are working to adapt their business models to the most important tech trends of the 21st century. And with their established and profitable business models, they both have their financial houses largely in order.
Which of these two companies, is the more appealing investment? Let's run IBM and Microsoft through a three-part analysis to see which tech stock looks like the better buy.
Here's a snapshot of some of the most important liquidity and solvency metrics for both IBM and Microsoft:
|Company||Cash and Investments||Debt||Cash From Operations||Current Ratio|
|Microsoft||$126.0 billion||$84.0 billion||$36.9 billion||2.8|
|IBM||$10.6 billion||$42.7 billion||$15.3 billion||1.2|
Microsoft comes out ahead against IBM in terms of net cash, cash flow generation, and short-term liquidity. With so one-sided an outcome, Microsoft wins this category handily.
But that doesn't mean IBM is in dire financial straits. In fact, the company's use of leverage is probably done with the intent of magnifying its return on equity (ROE). This might seem counterintuitive, but IBM probably elects to leverage its capital structure because its strong cash-generation capabilities allow it to support a sizable debt burden.
For context, debt allows companies to purchase more assets, which can be used to generate more profits for each dollar of equity a company carries. So while Microsoft is by far more profitable than IBM -- Microsoft sports 20% income margins versus 14% for IBM -- IBM's return on equity stands at 70% and Microsoft's ROE of 24%. Of course, leveraging a balance sheet can add risk in more volatile businesses. However, given the maturity and relative stability within its operating model, IBM can operate with an elevated amount of debt while not creating a big risk to its shareholders.
Durable competitive advantage
Microsoft continues to print profits from its Office suite of productivity software. Although the company doesn't say how much operating profit Office contributes, some rough math suggests that Office alone contributes at least half of the company's operating earnings.
To augment Office, Microsoft has made a major push into next-gen services, especially its cloud-computing platform. Its Intelligent Cloud segment increased its sales footprint from $21.7 billion in sales in fiscal 2014 to $25.0 billion in fiscal 2016, becoming Microsoft's second-largest source of revenue during that period.
IBM, meanwhile, is working to offset declines in its legacy businesses with investments in corporate IT services such as advanced analytics, security, and cloud computing, which the company collectively refers to as its Strategic Imperatives. Big Blue has made some impressive progress in this effort, as Strategic Imperatives sales rose 13% in the most recent quarter and accounted for 42% of the IBM's total for the period. The cloud-as-a-service business rose particularly quickly, increasing 35% over the prior quarter and achieving a 12-month equivalent run rate of $8.6 billion.
That said, IBM's transition has been a grinding one. For example, revenue has declined for 20 consecutive quarters, and news recently surfaced that billionaire superinvestor Warren Buffett's Berkshire Hathaway reduced its position in IBM by roughly one-third, which serves as a major vote of "no confidence" in the company's long-term direction.
Now let's look at the valuation fundamentals for IBM and Microsoft, keeping in mind the discussion of their durable competitive advantages. Here's an overview of the most common valuation metrics for each tech power.
The disparity between the two is obvious and probably justified, given IBM's multi-year growth issues. One metric to distinguish between their future growth potential is the five-year average annual EPS growth estimates. Wall Street currently estimates that IBM will compound its EPS by 2.5% annually over the next half-decade, whereas analysts project a 9.6% growth rate for Microsoft over this same period.
Seen that way, it doesn't seem unreasonable to say that neither company is an obvious steal. Rather, Microsoft and IBM appear to be fairly valued given their business' moats and expected growth. Let's call this aspect of our analysis a tie and move on.
And the winner is... Microsoft
As a result of its multi-year struggles, IBM is priced about as cheaply as a tech company can that isn't facing bankruptcy. Its growth concerns are real, which clouds its long-term prospects. Moreover, the continued durability of Microsoft's longtime profit centers and its progress in more effectively tapping into growth markets make shares of the Seattle-area software power the more appealing stock to own right now.
Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool's board of directors. LinkedIn is owned by Microsoft. Andrew Tonner has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.