IT Service Providers: Buy a Mixture of Momentum And Stability

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

With increasing innovation in technology, companies will almost inevitably demand greater consulting services to keep up. At the same time, FX headwinds and macro uncertainty is cutting into the bottom-lines and bookings of IT service providers. I thus recommend broadly diversifying off of both momentum and stability.

Buy Accenture (NYSE: ACN) Off Of Momentum

Over the last six months, Accenture has gained 11.8% in value and now trades at a respective 17.7x and 14.5x past and forward earnings, with a dividend yield of 2.4%. Analysts rate the stock a 2.1 out of 5, where "1" is a "buy," despite it recently hitting its 52-week high. There is good reason for this bullishness: over the last 5 years, free cash flow has grown from $2.1 billion to $3.9 billion - that's a 13.1% yield against the market cap.

During 4Q 2012, EPS of $0.88 represented a 2.2% year over year growth in revenue. The company also yielded $32.2 billion in new bookings (a record) and saw earnings hit the top-end of guidance. Performance was so strong that operating margins gained 30 bps--also at the top-end of guidance. Equipped with a balance sheet ($6.6 billion) and impressive free cash flow generation, the company is well positioned to further penetrate new markets. 

Going forward, the company is taking a different approach to create value. It is planning job cuts in Finland and rationalizing its cost structure generally. Clients have increasingly invested in restructuring to meet the challenges from technology changes in a globalized world. So, from a revenue perspective, Accenture will be there to pick up the demand with exposure to more than 120 countries and a leading brand name in emerging markets. 

The company, for example, is helping firms worldwide lower their own costs through supply chain function and finance & accounting management: for BP, it is consolidating their finance functions in North America and Europe; for Brazil's Oi, it is restructuring billings management.

Buy And Hold IBM (NYSE: IBM) Off Of Stability

After IBM dipped from $210 to under $195, many investors are questioning the company's long-term potential. At 13.9x past earnings, the stock looks compelling--especially when you consider that earnings growth over the past 5 years was in the double-digits. Moreover, earnings have been generally above expectations except for the last quarter, which was in-line.

There are several reasons why I believe you should be optimistic about IBM as a "buy and hold." First, the company has become more shareholder-friendly in its capital allocation policy. For example, the decision to add $5 billion to its now-$11.7 billion share repurchasing program goes a long way to reducing investor hesitation over the downside. It is important to note that the company has been able to beat quarterly EPS expectations in the recent past despite revenue declines, because of aggressive share buybacks. Second, FX headwinds have been offset by strong management of the cost structure that has held operating expenses flat

Around 1 year ago, Buffett disclosed his large $12 billion stake in IBM. The company is expected to grow EPS by 9.9% annually over the next 5 years. When complemented with limited volatility and low multiples, this growth rate is the perfect ingredient for "buy and hold" investors seeking medium risk for decent reward.

If you want to back a riskier company that could benefit from IBM's momentum, I recommend backing Xerox (NYSE: XRX). You may know the company for its copying service, but it is now a large IT outsourcer and provider of HR management. At a multiple of 7.3x and a turnaround from negative growth to positive growth, it is at a perfect inflection point for a takeover. With a free cash flow yield of 14.9% and a price-to-book value of 0.7x, a takeover would also be very risk-free. IBM could cross-sell Xerox's services to reinforce and sustain current clients. Even a 20% premium would mean that IBM is acquiring a business worth less than one-twentieth of the suitor's market cap. I recommend buying Xerox as the company recovers from its low in a greater IT environment.

TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of International Business Machines. Motley Fool newsletter services recommend Accenture Ltd. and 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.If you have questions about this post or the Fool’s blog network, click here for information.

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