IBM (NYSE:IBM) is one of the most iconic brands in American business history. It's nearly synonymous with the rise of modern computing and continues to be a major player in a number of burgeoning areas. The company has been undergoing a major refocusing for the past few years, and shareholders in Big Blue have taken it on the chin. I think IBM and its CEO, Ginni Rometty, are taking the necessary long-term steps to reinvigorate the business and deliver EPS growth for shareholders.
Sometimes the market can drastically misprice securities for years. I've seen this with AutoZone and Activision Blizzard, among many other examples. Years of flat or low stock-price appreciation allowed for massive buybacks and a compressed valuation that eventually caused the respective share prices to catapult when sentiment shifted and buyers poured in. I think IBM is setting itself for similar results in the years to come and Warren Buffett's confidence in the company bolsters my conviction.
Cloud is the new king
Amazon.com just delivered a stellar quarterly earnings report, and the star of the show was its cloud hosting platform. Microsoft, too, posted excellent results and is extremely bullish on its cloud service. Only a very few of the largest and best-capitalized companies can compete in this space, and IBM is one of them.
On Oct. 12, IBM announced that it won a $700 million cloud contract from Etihad Airways, beating out Amazon, Microsoft, and others. This is a space that's poised for tremendous growth, and it appears as though we're heading toward a sort of cloud-services oligopoly, with the previously mentioned companies and Alphabet all getting a piece of the pie. This bodes well for long-term IBM shareholders.
Hard to look past the short term
Revenue contraction is generally not a good sign for a business. If I'm selling $1 billion worth of widgets one year and $900 million the next, my business needs to be carefully looked at. But revenue is just like P/E, dividend yield, or any other financial metric, in that by itself it is of little utility. It's important to look deeper into the underlying business to give these numbers additional color.
IBM is undergoing a massive internal shift from being predominantly a hardware company to one focusing on higher-margin services and software. In doing so, IBM's top line has fallen from nearly $107 billion in 2011 to around $87 billion on a trailing-12-month basis. This is a serious haircut, but I believe that the market has more than accounted for it with IBM's valuation. The company sports a forward P/E under 10 and a dividend yield around 3.5%.
Don't believe me -- believe him
Retail investors are often clamoring for information about what Buffett is buying, hoping to piggyback on the great investor. He has certainly been wrong on a number of stock picks over his more than 50 years at the helm of Berkshire Hathaway, but not with his highest-conviction buys; IBM slots in at No. 3 in terms of value of shares on the list. Buffett has stated numerous times that he's very happy with the direction of the business and is delighted to see the share price fall. This has allowed management to aggressively buy back shares at cheaper and cheaper prices, thus giving remaining shareholders a larger claim on future earnings. The proof is in the pudding.
At some point in the future, for this to be a suitable investment, the direction of the stock must change. This will happen when investors begin to see the fruits of IBM's refocusing effort. As margins improve from operating in better business segments and earnings growth accelerates, investors should be very pleased.
Legendary investor Shelby Davis coined the term "The Davis Double Play." A company with earnings of $1 per share and a P/E ratio of 10 trades at $10. If earnings improve to $1.50 per share the following year, investors will often pour new money in, which may drive up the P/E ratio. If the P/E ratio increases to 12, the stock will now trade at $18. The early investor benefits from both an increase in EPS and multiple expansion.
I'm not sure when, but I'm fairly confident we'll be seeing something of the sort with IBM in the years to come. In the meantime, management will continue to buy back shares, the dividend provides some return (yielding 3.71% today), and the business transformation of IBM will continue.
James Sullivan owns shares of ATVI, AMZN, and BRK-B. The Motley Fool owns shares of and recommends ATVI, GOOG, GOOGL, AMZN, and BRK-B. The Motley Fool owns shares of MSFT. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.