As I read the business news headlines today, I mostly see claims of bubbles and that the markets are going to crash. Everybody seems to be calling for drops of 10, 20 and 30 percent. The odd thing is that when everyone is calling for the markets to drop, it goes higher. All the negative talk does have me thinking about adding some stability to the portfolio. I need an undervalued, large-cap stock with growth potential that is financially strong enough to withstand a market slowdown. Peter Lynch labeled this type of stock a "stalwart."
- Warren Buffett Recent Buys
- Warren Buffett's Current Portfolio
- This Powerful Chart Made Peter Lynch 29% A Year For 13 Years
I used the following screen at GuruFocus.com:
- Market cap over $50 billion.
- Business Predictability Rank of at least 4.
- Financial Strength with a minimum of 7.
- In the S&P 500.
- P/E of less than 15.
- 10-year EPS growth rate of 10% to 20%.
I did not want to have too high of a growth rate because it would not be sustainable. Business Predictability Rank is a score on a scale of 5 generated from a proprietary formula by GuruFocus. Financial strength is scored on a scale of 10 based on a formula used by GuruFocus.
After running the simple screen, IBM (IBM) was the only result. IBM is the stalwart.
- Market cap: $201.6 billion.
- Business Predictability Rank: 4.5.
- Financial Strength: 8.
- In the S&P 500.
- P/E: 12.8.
- EPS growth rate 10-year: 16%.
IBM has been in existence for over 100 years and will likely continue for decades to come. The company is able to innovate and change with the times. IBM originally started out developing punched card data processing equipment. Now the company is working to increase growth by focusing more on data analytics and the cloud.
The main segments for IBM are Services (54.7% of fourth quarter revenue), Software (29.6% of fourth quarter revenue), and Systems and Technology (16% of fourth quarter revenue). In the latest quarter, Software was the only segment with an increase in revenue at an increase of 3 percent. Services were down by about 2 percent and Systems and Technology were down 26 percent. The large drop in Systems & Technology is due to the cyclical nature of the mainframe business. Their System z was down 37 percent against a very strong quarter a year ago, when revenue was up 56 percent. IBM entered the backend of the cycle during the fourth quarter of 2013. IBM delivered higher gross margins on a lower revenue base.
IBM continues to focus on higher margin products and has recently sold two of its lower margin businesses. In February 2014, the company announced an initial closing of the sale of its customer care outsourcing business to SYNNEX for $505 million. The scope of the closing in the first quarter included 13 countries. The company expects the balance of the country closing to be completed in the second quarter. Most of the purchase price was paid by SYNNEX on Jan. 31. The remaining portion will be paid consistent with the closing of the remaining countries.
IBM announced on Jan. 23 that it will sell to Lenovo its System x, BladeCenter andFlex System blade servers and switches, x6-based Flex integrated systems, NeXtScale and iDataPlex servers and associated software, blade networking and maintenance operations. The transaction is expected to close later this year, subject to the satisfaction of regulatory requirements, customary closing conditions and any other required approvals. The acquisition is for approximately $2.3 billion. The deal has come under government scrutiny due to national security concerns. Many U.S. government agencies, including the Pentagon and the FBI, buy their servers from IBM. Lenovo is a China-based company and there are concerns that U.S. government data could be accessed by the the Chinese government. If the deal falls apart, Lenovo will pay a termination fee of more than $200 million.
Chairman, President and CEO Virginia Rometty listed three strategic imperatives for IBM in her latest letter to shareholders.
The first imperative is to make markets by transforming industries and professions with data:
"The market for data and analytics is estimated at $187 billion by 2015. To capture this growth potential, we have built the world's broadest and deepest capabilities in Big Data and analytics-both technology and expertise. We have invested more than $24 billion, including $17 billion of gross spend on more than 30 acquisitions. We have 15,000 consultants and 400 mathematicians. Two-thirds of IBM Research's work is now devoted to data, analytics and cognitive computing. IBM has earned 4,000 analytics patents. We have an ecosystem of 6,000 industry partners and 1,000 university partnerships around the world developing new, analytics-related curricula."
The second strategic imperative is to remake the enterprise IT infrastructure for the era of the cloud:
"As important as cloud is, its economic significance is often misunderstood. That lies less in the technology, which is relatively straightforward, than in the new business models cloud will enable for enterprises and institutions. This is creating a market that is expected to reach $250 billion by 2015.
IBM today is the leader in enterprise cloud, a position we have enhanced through investments of $7 billion on 15 acquisitions, most notably SoftLayer in 2013. We provide the full spectrum of cloud delivery models - infrastructure as a service, platform as a service, software as a service and business process as a service. IBM's cloud capabilities are built on 1,500 cloud patents and supported by thousands of cloud experts. Eighty percent of Fortune 500 companies use IBM's cloud capabilities."
The third strategic imperative is to enable "systems of engagement" for enterprises:
"Complementing traditional back-office systems of record, enterprises are now taking a systematic approach to engagement with all of their constituencies - customers, employees, partners, investors and citizens. Indeed, 57 percent of companies now expect to devote more than a quarter of their IT spending to these new systems of engagement by 2016, nearly twice the level of 12 months ago.
They are doing so because the way their customers and their own workers expect to engage is undergoing profound change. Seventy percent of people who contact a company via social media today expect a response within five minutes. Nearly 80 percent of adult smartphone users keep their phones with them an average of 22 hours a day. This is why we launched IBM MobileFirst in 2013, and why we have made eight acquisitions to advance our mobile initiatives. We have 3,000 mobile experts, and have been awarded hundreds of patents in mobile and wireless technologies."
The most interesting development is the establishment of a new business unit for Watson. It was announced in January that more than a billion dollars will be invested to start the unit. Watson is an artificial intelligence super computer system named after legendary IBM president Thomas Watson. It uses natural language capabilities and analytics similar to how people think where it can quickly analyze and interpret large amounts of data. Watson has the ability to learn as well.
Watson made a public appearance on Jeopardy in 2011 and beat two of the best players of all-time. Watson can help in many areas ranging from the medical field to the financial industry, and even customer service call centers. The current project in the medical field involves Watson being taught medicine, so it can help provide treatment options for patients. The plan is for Watson to be available through the cloud at any time. IBM recently issued a challenge for mobile developers to bring Watson to your phone. Get ready for a Watson versus Siri battle. IBM previously said that Siri and Watson are not competitors because Watson has conversations and learns from them, whereas Siri just does Q&A.
The first thing I notice about IBM is their high return on equity (ROE). The ROE has been increasing at a large rate almost every year for the past 10 years. In 2004 it was at 23.60 percent and for year 2013 it was at 72.32 percent. That is over a 200 percent increase. When looking at why their ROE has gone up so much, their financial statements will show that their net margins have more than doubled, and their leverage has gone up 58 percent. A large increase in leverage would usually be a cause for some worry. The increased leverage is due to the share buybacks in this case. IBM has enough operating income to cover its interest over 46 times. That makes its interest expense almost non-existent. The strong balance sheet is why IBM receives a score of 8/10 for financial strength. The 10-year financials can be viewed on one screen at GuruFocus.
In the latest conference call, CFO, Martin Schroeter stated that IBM expects to deliver at least $20 of operating EPS in 2015. Over the past 10 years a dollar in operating EPS has translated into a bottom line of $0.8063 of EPS. Therefore, $20 in operating EPS will lead to an overall EPS of about $16.13. What is interesting about IBM's recent earnings is that all of it has been going towards dividends and share buybacks. For 2013, the dividend was $3.70 per share and they spent $1.4 billion on share buybacks. $1.4 billion equates to $12.96 per share. That is why very little, if any, of the high ROE has been translating into high increases in EPS. The buybacks do have a positive effect by lowering the shares outstanding, thereby increasing EPS. If continued at the same rate, the buyback would decrease the number of shares by 6.7 percent for 2014.
Shares Outstanding (millions)
The stock is held by 30 gurus we follow. Warren Buffett (Trades, Portfolio) is the largest shareholder with just over 68 million shares amounting to 6.54 percent of the outstanding shares. IBM is the only tech stock he has invested in. He started buying the stock in 2011, and his average purchase price is $171.47 per share. Buffett expected IBM's buybacks to continue. He made the following statement in his 2011 letter to shareholders:
"Today, IBM has 1.16 billion shares outstanding, of which we own about 63.9 million or 5.5%. Naturally, what happens to the company's earnings over the next five years is of enormous importance to us. Beyond that, the company will likely spend $50 billion or so in those years to repurchase shares. Our quiz for the day: What should a long-term shareholder, such as Berkshire, cheer for during that period?
I won't keep you in suspense. We should wish for IBM's stock price to languish throughout the five years."
His reason for wanting the company to "languish" was so that it can buy back its shares at a low price. Five years is almost up, and the company has been buying back shares just like Buffett predicted. If IBM can maintain a high ROE, it would be beneficial to reinvest more of the earnings into the company rather than use it all for buybacks.
When looking at the price of the stock compared to its operating earnings for the past 10 years, the average price to operating EPS is 11.56. I removed the extreme values of 17.5 in 2004 and 7.3 in 2008 when determining the average. If operating EPS is estimated to be at least $20 per share by the end of 2015 that would lead to a value of $231.20 (20 x 11.56). The next step is discounting it back. We can use CAPM, and I get a figure of 8.3 percent due to IBM's low beta of 0.7. We have 1.67 years until the end of 2015. Discounting $231.20 back 1.67 years gives us a value of $202.38. If we ignore beta and discount it back, we get a value of $195.10. In conclusion, IBM is slightly undervalued with value range between about $195 and $202. Its financial strength and lower volatility warrants a price closer to the upper end of the range.
This article first appeared on GuruFocus.