Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...
Pity IBM (IBM 0.34%) stockholders. After reporting earnings Tuesday evening, shares of International Business Machines promptly slid 4.2% in Wednesday trading. Over the past year, the S&P 500 is up nearly 14% -- but as of today, IBM stock is down more than 4%. Even with IBM paying a massive dividend yield of 4.1%, investors who've held this stock for a year are sitting on a loss.
But perhaps not for long. Here are three things you need to know about that.
1. Taking a stand on IBM
Many investors are fleeing IBM stock this week. But as reported today on StreetInsider.com (requires subscription), veteran stock market analyst Standpoint Research is viewing this panic as an opportunity. Arguing that no stock can fall forever, Standpoint planted its flag in IBM stock this morning. The analyst assigned IBM (currently at $147 and change) a $180 price target and declared the stock a buy.
2. Reversion -- what it means
A confirmed fan of the "reversion to the mean theory" of investing, Standpoint Research operates on the supposition that great stocks tend to outperform the average performance on the S&P 500 and lousy stocks tend to underperform it -- but over long periods of time, most stocks track the performance of the S&P 500 stock market average. When a great company like IBM lags too far behind, therefore, Standpoint often makes a wager on the stock eventually catching up -- rather than the rest of the market slowing down.
It's a simple theory, but like many things simple, it evidently works really well for Standpoint. According to our data here at Motley Fool CAPS, following this approach has helped Standpoint Research rack up a record of nearly 70% accuracy (69.57% to be precise) on its picks -- and this is on a record that stretches back more than a decade.
3. Why IBM might revert
So why might it work really well in IBM's case? IBM's gross and operating profit margins are entering their third straight year of continuing declines. According to data from S&P Global Market Intelligence, IBM boasted a gross profit margin of 50% as recently as 2014, but that number has slipped to 46.5% over the past 12-month period. Operating profit margin has suffered even more, falling from 21.7% to 17.2% over the same period -- a drop of 450 basis points.
And yet, Standpoint believes that "margins may have bottomed out and stabilized" for IBM. Although down again year over year in IBM's Q2 report, both gross and operating profit margins (and net margin, too) are up sequentially. Standpoint's "bet" is that "a margin bounce ... could get the share price back near $180 by 2018-2019."
The most important thing: Valuing IBM
Is Standpoint right about IBM's impending "margin bounce"? It could well be. In IBM's after-earnings conference call with analysts, CFO Martin Schroeter noted that IBM's "gross margin is up over two-and-a-half points sequentially," and predicted "improved performance in revenue and gross margin in the second half" of 2017.
For the full year, IBM says it expects to earn $11.95 in net profit, with free cash flow equal to last year's $13.4 billion -- which would be an improvement over the $12.2 billion in cash that IBM generated over the last 12 months.
Valued on earnings, IBM stock now sells for 12.3 times that current-year earnings projection. Valued on free cash flow, the stock sells for 10.3 times FCF. Those don't seem to be expensive valuations, except for two things:
First, valuations based on market capitalization alone don't take into account IBM's $33.4 billion in net debt on its balance sheet. Factor that debt into your calculations, and IBM stock is arguably about 24% more expensive than its market cap alone makes it look. Second, while Standpoint seems convinced IBM's margins will bounce, and management backs it up, other analysts aren't so sure. Morningstar projections call for the S&P 500 as a whole to grow earnings at about 9.6% annually over the next five years. But the projection for IBM stock in particular is for much more muted 4% annualized growth.
If Standpoint is right, and IBM stock succeeds in growing at least as fast as the rest of the stock market, then with its 4.1% dividend yield I'd say there's at least a case to be made that IBM is selling for close to fair value. But if the best IBM can achieve is only 4% growth, it may be safer to stay away.