Company Background (sourced from Yahoo! Finance):
International Business Machines Corporation provides information technology (IT) products and services worldwide. The company operates in five segments: Global Technology Services, Global Business Services, Software, Systems and Technology, and Global Financing. The Global Technology Services segment provides IT infrastructure and business process services, including outsourcing, process, integrated technology, and technology support. The Global Business Services segment offers consulting solutions for strategy and transformation, application innovation, enterprise applications, and smarter analytics; and application management, maintenance, and support services. The Software segment offers middleware and operating systems software, such as WebSphere software to integrate and manage business processes; information management software for database and enterprise content management, information integration, data warehousing, performance management business analytics and intelligence, and data analytics; Tivoli software for cloud and datacenter management, enterprise endpoint and mobile device management, asset and facilities management, storage management, and security systems; Lotus Software to connect people and processes for communication; rational software to support software development in IT and embedded systems; and operating systems software. The Systems and Technology segment provides computing power and storage solutions; and semiconductor technology, products, and packaging solutions. The Global Financing segment provides lease and loan financing to end users; commercial financing to dealers and remarketers of IT products; and remanufacturing and remarketing services for equipment. The company has a strategic alliance with Kutxabank. The company was formerly known as Computing-Tabulating-Recording Co. and changed its name to International Business Machines Corporation in 1924.
Analysts expect IBM to grow earnings 10.59% per year for the next five years and I've assumed they can continue to grow at 2/3 of that rate, 7.06%, for the next three years and then 3.50% per year thereafter. Running these numbers through a three stage DCF analysis with a 10% discount rate yields a fair value price of $363.56. This means the shares are trading at a 47.9% discount to the discounted cash flow analysis.
The Graham Number valuation method was conceived of by Benjamin Graham, the father of value investing, and calculates the maximum price one should pay for a company given the earnings and book value. IBM earned $14.08 per share in the last twelve months and has a current book value of $16.14. The Graham Number is calculated to be only $71.51, suggesting that IBM is overvalued by 164.8%.
Average High Dividend Yield:
IBM's average high dividend yield for the past 5 years is 2.07% and for the past 10 years is 1.79%. This gives target prices of $183.36 and $211.70 respectively based on the current annual dividend of $3.80. I think the average high dividend yield will slowly creep up but slightly over the 2.00% level is reasonable for the next few years. For that reason I'll use the 5 year average. IBM is currently trading at a 3.3% premium to this price.
IBM's average low PE ratio for the past 5 years is 10.79 and for the past 10 years is 11.89. This corresponds to a price per share of $182.43 and $201.05 respectively based off the analyst estimate of $16.91 per share for fiscal year 2013. The average low PE ratio has been trending down since the end of dotcom boom and subsequent bust, so I'll use average of the two giving a price target of $191.74. IBM is currently trading at a 1.3% discount to this price.
Average Low P/S Ratio:
IBM's average low PS ratio for the past 5 years is 1.65 and for the past 10 years is 1.44. This corresponds to a price per share of $154.28 and $137.76 respectively based off the analyst estimate for revenue growth from FY 2012 to FY 2013. Currently, their current PS ratio is 2.01 on a trailing twelve months basis. I'll use the average of the two since the low P/S ratio has been creeping higher over the last few years. This gives a target price of $144.52 which means IBM is trading at a 31.0% premium to this price.
Dividend Discount Model:
For the DDM, I assumed that IBM will be able to grow dividends for the next 5 years at the minimum of 15% or the lowest of the 1, 3, 5, or 10 year growth rates. In this case that would be 12.12%. After that I assumed they can continue to raise dividends for 3 years at 75% of 12.12% or 9.09% and in perpetuity at 3.50%. The dividend growth rates are based off fiscal year payouts and don't necessarily correspond to quarter over quarter increases. To calculate the value I used a discount rate of 10%. Based on the DDM, IBM is worth $92.37, meaning it's over valued by 105.0%.
IBM's trailing PE is 13.45 and it's forward PE is 10.32. The PE3 based on the average earnings for the last 3 years is 14.58. I like to see the PE3 be less than 15 which IBM is currently under. Compared to it's industry, IBM seems to be undervalued versus ACN (16.30) and ORCL (14.71). All industry comparisons are on a TTM basis. IBM's PEG for the next 5 years is currently at 1.05 while ACN is at 1.73 and ORCL is at 1.08. Based on the PEG ratio, you're getting about the same growth at current prices from IBM and ORCL but you could be overpaying for growth of ACN.
IBM's gross margins for FY 2011 and FY 2012 were 51.4% and 52.6% respectively. They have averaged a 48.1% gross profit margin over the last 10 years with a low of 42.3% in FY 2003. Their net income margin for the same years were 14.8% and 15.9%. Over the last 10 years their net income margin has averaged 11.8% with a low of 8.5% in FY 2003. I typically like to see gross margins greater than 60% and at least higher than 40% with net income margins being 10% and at least 7%. IBM is under the my gross margin target but has improved significantly over the last decade on their net income margin and are well over the 10% target. Since each industry is different and allows for different margins, I feel it's prudent to compare IBM to its industry. For FY 2012, IBM captured 126.7% of the gross margin for the industry and 176.7% of the net income margin. This is what I expect from one of the global leaders in the technology space. Other companies are willing to pay a premium to have access to all of IBM's R&D, products, and services.
IBM' has committed to buying back shares as a way to return cash to shareholders. Since FY 2001, they've purchased over 34% of their shares outstanding for an average annualized decrease of 3.8%. Buybacks are great as long as they are purchasing shares at a value price point, otherwise they are reducing shareholder value through the buyback program. Looking at the historical data, the increased buyback program coincides with better value prices available in the market. By repurchasing shares, IBM is able to increase EPS and management can return cash to shareholders this way by increasing the ownership stake of the company for all the outstanding shares.
A negative number for the % change value means shares were bought back by the company and a positive value means the shares outstanding increased.
IBM is a dividend contender with 18 consecutive years of dividend increases. For a technology company that is pretty outstanding as most tech companies suffered greatly during the dotcom fallout and typically need to reinvest most of their earnings back into the company. They have increased the dividend at a 12.12%, 13.96%, 14.26%, and 19.37% rate for the last 1, 3, 5, and 10 year periods. In typical fashion the price has grown along with the dividend albeit not as fast. Their current yield is 2.01%. Their payout ratio based off EPS has almost doubled since FY 2001 which has allowed the dividend to increase faster than EPS have grown, although it's still at a very manageable 23% for FY 2012. Going forward I expect the dividend growth to still outpace earnings growth due to the large share buybacks and an increasing payout ratio. Due to managements' willingness to increase the dividend faster than earnings I expect that trend to continue since there's still plenty of earnings to reinvest in the company.
IBM is a cash generating machine. Their free cash flow has grown from $8.61B in 2001 to $14.54B in 2012, good for a 14.65% annualized increase. The free cash flow after dividends have been paid has risen from $7.64B to $10.62B over that same time for a 9.78% annual increase. The free cash flow payout ratio has averaged 17.8% since FY 2003, which is just a bit higher than the payout based on earnings. Annual total shareholder return when accounting for buybacks plus dividends has averaged 96.32% of FCF since FY 2003 so it will have to come down or management will be forced into a major decision. This is mainly due to the absurdly high buyback plan where they've spent over $42.42B on buybacks in the last three fiscal years. I would like to see the buyback program scaled back some with more of the cash devoted to dividends but I don't really have much of a say in that. Debt levels have been increasing which has allowed has helped to fund some of the buyback.
Return on Equity and Return on Capital Invested:
IBM's equity stake has decreased since FY 2001 and now sits at $18.86B with a total debt level of $33.27B. Currently their debt to equity ratio is at 1.76. I would much prefer to see the debt level come down from current levels although it's not as dire a situation as it looks as IBM has essentially formed it's own financing arm and most of the debt is related to that. This allows them to finance the purchases from their customers which can potentially bring in more customers but is still a double-edged sword since those companies could overextend themselves and default on their loans. For a more in depth analysis of the debt levels check out this article on Seeking Alpha. Their ROE for FY 2012 was a pretty ridiculous 88% although that has been achieved through lower equity (i.e. more debt) and better efficiency within the company. Their ROE has averaged 53.2% since FY 2003. Their ROCI is equally impressive growing from 16.9% in FY 2003 to 38.7% in FY 2012 with an average of 26.8%. I don't necessarily look for any specific levels for ROE or ROCI but prefer to see stable to increasing levels. IBM has increased both ROE and ROCI over the last 10 years and while I don't expect either to continue growing at the past rates and to probably level out. I would actually prefer to see the ROE decrease some if it's due to the the equity portion increasing and thus yielding a lower ROE.
Revenue and Net Income:
Since the basis of dividend growth is revenue and net income growth, we'll now look at how IBM has done on that front. Their revenue growth since 2002 has been pretty unspectacular at just 2.56% annual increases. Although their net income growth has been incredible as 16.59% annual increases. This has led to a almost quadrupling of their net income margin since 2002's 4.41% to 2012's 15.89%. IBM has been able to increase efficiencies in their operations as well as push higher margin products/services to their customers. I hope to see their revenues grow at a faster rate in the future; however, analysts are expecting -2.00% sales growth from 2012 to 2013 and 2.30% growth from 2012 to 2014. This is something to be concerned with as technology hardware doesn't "age" as fast as it used to which means longer replacement/upgrade intervals.
The average of all the valuation models gives a target entry price of $174.51 which means that IBM is currently trading at a 8.5% premium to the target entry price. I've also calculated it with the highest and lowest valuation methods thrown out. In this case, the DCF and Graham Number valuations are removed and the new average is $153.00. IBM is trading at a 23.4% premium to this price as well.
Assuming that IBM can grow their earnings and dividends at the rates that I assumed, you're looking at solid returns over the next 10 years. In 2023, EPS would be $34.86 and slapping an average PE of 12.94 gives a price of $321.07. Over the next 10 years you'd also receive $69.64 in dividends for a total return of 238.22% which is good for a 10.65% annualized rate if you purchase at the current price. If you purchase at my target entry price of $174.51, your projected 10 year total return jumps to 258.42% for an annualized return of 11.55%. The payout ratio based off earnings would only be 26% if the assumed rates come true so there's still plenty more room for dividend growth.
According to Yahoo! Finance the 1 year target estimate is at $217.80 suggesting plenty of room for capital gains at current price levels. Morningstar has IBM rated as a 3 star stock meaning it's a hold. Here's a snapshot from Morningstar's valuation page on IBM.
I was really surprised to see that IBM's revenue growth has pretty much stalled over the last 10 years. I know some of that is due to their size but I would have expected to see higher than just 2.5% annual growth. One major issue with IBM is that they are in the technology sector which usually requires large amounts of R&D to maintain an advantage. And even then there's always breakthroughs that no one was expecting. Another is that due to the advances in technology the replacement intervals have increased. Tech products now stay relevant longer meaning that as a company you're not completely behind your competitors just one or two years after a replacement cycle. There have been struggles with IBM but I believe a lot of that can be attributed to the overall sluggish "recovery" we've seen since the depths of the financial crisis. If the economy really does start to grow at a more normal rate, I expect IBM to benefit. Management's goal is to reach $20.00 per share earnings by 2015.
Recently Credit-Suisse has downgraded IBM stock and that led to a 2.5% drop. The Credit-Suisse report has largely been considered pretty flimsy and the timing of it was pretty shady as well. For long-term dividend growth investors I think that IBM represents a pretty good value at current prices because I expect dividend growth to be 10%+ for several more years. Selling puts is pretty much out of the question unless you have very high conviction in the company as it would require around $19,000 to purchase the shares should the put be executed. I'm looking to try and pick up some shares of IBM at a little bit lower prices from here, probably somewhere around $187-188 to start a position. Of course, that's if it's still in this area when I can finally start investing again sometime in September.
To check out more reports check out my Stock Analysis page.
What do you think about IBM as a DG investment at today's prices? How do you think the long-term dividend growth prospects are?