Following the stock market's dramatic rise over the past five years, finding bargains has become much more difficult. The S&P 500 currently sports a P/E ratio near 20, well above the long-term average of around 15, and these days, it often takes a big decline, driven by lackluster earnings or extreme pessimism, to drive a stock into value territory.
In the realm of technology stocks, there are at least two instances where exactly this has happened. Microsoft (NASDAQ:MSFT), which has soared over the past few years as the market realized the PC wasn't dead, took a big hit after reporting disappointing earnings last month. And International Business Machines (NYSE:IBM), a company investors love to hate, has seen its shares sink on worries over the lack of growth and falling profits.
Both of these stocks now offer a value opportunity for investors.
The resurgence of Microsoft
The narrative over the past few years has been that mobile devices, running Android or iOS, along with PC-alternatives like Chromebooks, are putting Microsoft's Windows empire at risk. Windows 8 is widely disliked, although I believe that perception is the main problem at this point, and PC sales have been declining over the past few years.
At the same time, the cloud threatens to disrupt Microsoft's extremely profitable dominance of the productivity software market. Google has been pushing its productivity suite to enterprise customers, and consumers have turned to the free, browser-based Office alternative in droves.
Despite all of this, Microsoft's business has been booming over the past couple of years. Revenue has been growing, operating margins have remained around 30%, lower than in the past mainly because of new hardware businesses and heavy investments in the cloud, and the company has been throwing off in excess of $25 billion in free cash each year.
The recent hiccup, which sent Microsoft's shares falling nearly 10% in a single day, was an overreaction. Businesses are not going to stop using Windows, and for the most part, they're not going to stop using Office. There have been free alternatives to both for years, in the form of countless Linux distributions and open-source productivity suites, and neither has made a dent in Microsoft's business. And beyond Windows and Office, Microsoft has more than a dozen other businesses that generate over $1 billion per year in sales, and many of these are growing at a healthy rate.
Adjusting for Microsoft's enormous pile of cash, the stock trades at a P/E ratio of just about 13. Microsoft certainly isn't as cheap as it was a few years ago, but the market reaction to Microsoft's recent earnings gives long-term investors a chance to buy the stock at a good price.
Haters gonna hate
An awful lot of criticism gets thrown IBM's way. The lack of revenue growth, massive share buybacks masking structural problems, and the recent bonus given to CEO Ginni Rometty for a lackluster year are a few examples. Not to mention the near-constant workforce rebalancing efforts.
It's certainly true that IBM is going through a difficult transition. It's been divesting low-margin businesses, like x86 servers, causing revenue to decline, and its investments in the cloud will take time to fully pay off. IBM is often called a dinosaur, criticized for missing the boat on various tech trends. The company was late to focus on the cloud, and its presence in the mobile market, other than its partnership with Apple, is minimal.
IBM has never been a company that chases trends. It hasn't been what many would consider a "cool" tech company for a long time. But the core of its business -- software, services, and mainframe systems -- remains both strong and resilient.
Mainframes continue to be vitally important, and many industries rely on IBM's systems for mission-critical applications. That's not going to change anytime soon. IBM's software business, which generated $7.6 billion in revenue during the fourth quarter, has a pre-tax margin of nearly 45%. And IBM's massive services business maintains a backlog of $128 billion, unchanged compared to one year ago, adjusted for divestitures and currency fluctuations.
IBM currently trades right around 10 times earnings, and with about $13 billion in annual free cash flow, the company can afford to continue to plow cash into buying back its own shares. At current prices, there's no reason not to. As Warren Buffett pointed out in his 2011 shareholder letter, a languishing stock price for IBM means the company gets more for its money when it buys back its own shares, ultimately benefiting shareholders.
It will probably be a rough ride for IBM shareholders in the short term. But for long-term investors, the current price offers a great entry point.