Why This Constantly Evolving Tech Giant Belongs in Your Portfolio

Matthew is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

When most casual observers hear the name International Business Machines (NYSE: IBM), better known simply as IBM, they recognize the company as the father of the modern PC. For those readers who aren’t quite old enough to remember, computers used to be split into two categories: Macintosh (Apple) and IBM-compatible, regardless of who the actual manufacturer was. 

However, what most people don’t realize is that IBM has evolved into so much more than that. In fact, IBM exited that sector when they sold their PC business to Lenovo (NASDAQOTH: LNVGY.PK) back in 2005. IBM in its current form is quite an interesting company, and one that trades at a very fair valuation. I’d like to take a closer look at the IBM of today and where they may be headed; then we’ll take a brief look at some of the other choices in the sector to try to find the best deal.

IBM in 2013 (and beyond)

IBM has gotten out of the PC business and is now a systems, servers, and software company. It is one of the leading server distributors and software companies and has the leading market share in global technology services. The company separates its business into three segments, one for each of the three business areas. 

The Systems and Technology segment accounts for about 17% of the company’s revenue and mainly provides servers and computing infrastructure to businesses around the world. The Software segment makes up 24% of IBM’s sales and provides software solutions for business that complement its server offerings. Finally, the largest segment is Services, at 56% of revenue, and includes strategic outsourcing and integrated technology services, as well as IBM’s business services division.

While IBM’s businesses are becoming somewhat mature with their excellent global presence and market-leading status, there is still plenty of room to create value for IBM’s shareholders. The company is actively trying to grow through acquisitions, mainly in the software division, which carries with it higher profit margins than IBM’s other business segments. 

The company also has one of the best share repurchase programs in the entire tech sector, and since 2009 has reduced the total amount of outstanding shares from 1.34 billion to 1.1 billion, a reduction of about 18% in just four years. Additionally, the company pays a modest but respectable dividend yield of 2%, which has been raised consistently since they started paying dividends in 1916.

The numbers

At the current share price, IBM trades for just 11.5 times 2013’s expected earnings of $16.69 per share. As a result of higher margins from their increased projected software sales, as well as increased overall revenue increases due to the improving U.S. (and global) economy, analysts expect IBM’s earnings to grow at around 10% annually over the next several years. The consensus for next year (2014) is for $18.30 per share, for year-over-year growth of 9.7%, which is great for such a low P/E ratio. Additionally, IBM has an excellent balance sheet which features, among other things, over $11 billion in cash.

Alternatives: Lenovo and Cisco Systems

While there is no doubt in my mind that IBM is a great, attractively priced investment regardless of what other companies are trading for, let’s take a quick look at a couple of alternatives to see how they compare. Although it is not an apples-to-apples comparison by any means, Lenovo is a good place to start since it consists of the PC business that a lot of casual investors still associate with IBM.

In addition to PC’s, Lenovo manufactures servers, tablets, smartphones, batteries, cables, and many other computing accessories. While Lenovo is very good at what it does, I’m hesitant to get involved with an investment in the PC business right now, as the future is very uncertain. With tablets and smartphones just beginning to show their full potential, there is no telling the role PC’s will play in the new computing landscape a few years from now. Lenovo does make tablets and smartphones, but it is just a fraction of their business currently.

Cisco Systems (NASDAQ: CSCO) may be a better alternative, and closer to IBM in terms of its business model. Cisco is one of the world’s largest networking and communications companies, with almost $48 billion in revenue over the past year. Cisco trades at a slightly higher valuation of 12.6 times 2013’s expected earnings, but has some advantages, such as a higher dividend yield of 2.8%. While I love Cisco as a company and a long-term investment, it is trading right at its 52-week high and I would like to see somewhat of a pullback before jumping in.

Buy, sell, or hold?

As far as IBM goes, I think it is one of the most attractively valued stocks, not just in the tech sector but in the entire market. The consensus 1-year price target among all of the analysts who follow the company is about $221, about 15% above the current share price. I actually find this number to be a bit conservative, especially if IBM can deliver on their growth projections over the next few years. Also, IBM’s track record of creating value for its shareholders speaks for itself, and should continue for decades into the future.

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Matthew Frankel has no position in any stocks mentioned. The Motley Fool recommends Cisco Systems. The Motley Fool owns shares of International Business Machines.. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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