Shares of IBM (NYSE:IBM) have fallen 16% over the past 12 months, underperforming the S&P 500's 9% gain. But after that dip, many contrarian investors might be wondering if IBM is a worthy long-term buy. In previous articles, I highlighted IBM's main strengths and weaknesses. Today, we'll weigh them against each other to decide if IBM is worth buying.
What the valuations tell us
Over the past 12 months, IBM's trailing P/E has fluctuated between 11.5 and 15.5. As of this writing, the stock trades for 13 times earnings. This makes it fundamentally cheaper than industry peers Microsoft and Accenture, which trade for 17 and 19 times earnings, respectively. It is slightly pricier than Hewlett-Packard, which has a P/E of 12.5. However, IBM still trades at a discount to the S&P 500, which trades at 19 times trailing earnings.
In terms of long-term earnings growth, expectations aren't high. IBM's 5-year PEG ratio, based on Thomson Reuters estimates, is the same as Microsoft's at 2.2. Accenture and HP have slightly cheaper PEG ratios of 1.9 and 2.1, respectively. Nonetheless, those ratios suggest that none of these tech giants will report explosive earnings growth anytime soon.
IBM's most important asset is its growing cloud-based business, which increased its revenue 60% year over year to $7 billion in 2014.
In 2013, IBM acquired cloud computing infrastructure company SoftLayer Technologies for $2 billion. Last year, it bought cloud security firms CrossIdeas and Lighthouse Security Group. It also committed $1.2 billion to expand its cloud presence with the formation of the IBM Watson Group, which will explore new data analytics uses for its Watson AI. CEO Ginni Rometty believes that Watson could evolve into a $10 billion business within the next decade.
IBM also signed an enterprise partnership with Apple. IBM will launch native apps for businesses and optimized cloud services on iOS, which will be preloaded on iPads for sales to enterprise clients.
Last but not least, IBM recently signed a series of major "hybrid cloud" deals with Lufthansa, ABN Amro, and WPP. Hybrid cloud installations add cloud-based features to existing hardware, bridging the gap between private and public clouds -- an ideal choice for large companies which don't want to move all of their data off-site. Gartner estimates that half of all U.S. companies will use hybrid cloud installations by 2017.
Despite IBM's promising growth in the cloud, this business area still only accounted for 7.5% of its 2014 revenue.
Unfortunately, IBM's companywide sales have fallen for 11 consecutive quarters. Last quarter, revenue in the technology services, business services, software, and systems/technology businesses all declined year-over-year. IBM blamed those declines on sluggish demand across the software sector, weak client spending, the divestment of lower margin businesses, and a strong dollar reducing its overseas revenue.
A core problem that has haunted IBM was former CEO Sam Palmisano's promise of doubling annual EPS from $10.01 in 2009 to $20 by 2015. To reach that goal, IBM aggressively bought back stock (partially financed by debt), dumped lower margin businesses, slashed jobs, and failed to invest enough in higher-margin sectors like cloud services. That arguably myopic strategy caused IBM's top line growth to stall out.
In January, CFO Martin Schroeter stated that IBM will spend the least amount on buybacks in 2015 that it has in 11 years, causing buybacks to be less of an earnings driver this year. On one hand, that decreases IBM's slavish dependence on buybacks. But on the other hand, IBM will need its core businesses to bounce back and cloud revenues to grow faster to pick up the slack.
IBM is clearly a company in transition. Big Blue languished for too long under Palmisano's furniture-burning strategies, but at least Rometty now nurtures the growth of a few green shoots. IBM's downside is likely limited, since it now trades at just 9 times forward earnings, but it doesn't have much upside potential either.
However, IBM still pays a decent 2.8% forward dividend yield, which makes it ideal for conservative income investors. However, investors looking for mature tech stocks with higher growth potential should probably consider Intel or Microsoft -- which both have more visible catalysts on the horizon -- instead.