How To Get a Mix of Stability, Upside in Tech

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

It seems like every other quarter brings a major secular transition in technology. In light of the volatility, investors should buy across several risk/reward scenarios: stable producers, blue-chip stocks with a meaningful margin of safety, and high-growth innovators. I encourage (1) considering free cash flow yield and its relation to R&D investments to gauge whether innovation has been successful and (2) looking for diversification in businesses where core segments are eroding. With these points in mind, I review 3 tech stocks below.

Stability Key To IBM (NYSE: IBM): "Buy"

As one of the most iconic blue-chip companies in technology, IBM has a lot to offer at current prices. It trades at only a respective 13.9x and 11.6x past and forward earnings and has steady growth ahead (forecasted for 10% gains in EPS over the next 5 years). Stifel Nicolaus released a report on Oct. 15 calling it a $243 stock. While I don't see the company outperforming broader indices, it provides nice stability. Free cash flow has increased from $10.3 billion in 3Q07 to $16.6 billion today--a CAGR of 10%. This, combined without the 35.4% return on invested capital, is more than enough to generate meaningful value creation.

It should be of no surprise then that value investor Warren Buffett has parked over $10 billion of Berskhire capital into the business. In the third quarter, EBIT per share grew 10% to $3.62. The return was largely due to a strong annuity base and productivity improvements. Management is targeting $8 billion worth of productivity improvements by 2015, which is nicely complemented by a transition to more profitable lines. Business analytics, smarter planet, and cloud solutions--pieces of the Global Business Services segment--continue to be major value drivers.

Nice tailwinds are coming from double-digit growth in Russia, India, and China. All told, 35 emerging markets yielded double-digit returns for IBM in the third quarter. Revenue in Japan stabilized while North American business declined. Greater contribution from the growth markets is also doubly beneficial--it expands margins. Management has successfully hedged against FX headwinds, and this year these initiatives saved about $100 million.

Oracle (NYSE: ORCL), Cisco (NASDAQ: CSCO): Both Have More Upside

If you are looking for stronger upside in the tech space, I recommend either Oracle or Cisco. The former has potential on the rise of cloud services while the latter has potential on the rise of mobile and data security sales. Oracle trades at a respective 15.3x and 10.6x past and forward earnings with strong free cash flow generation. FCF has soared dramatically over the years and now stands at $13.4 billion, or a 9% yield. Perhaps most importantly, growth in R&D expenditures have led to an even greater growth in free cash flow. So, management is investing wisely. Gross, operating, and profit margins have all been on the increase as well.

Assuming expectations are met, 2016 EPS will come out to $4.08. At a multiple of 14x, this translates to a future stock value of $57.12. Discounting backwards by 10% yields a present value of $35.50. This is at a good enough premium to the current market cap to warrant an investment based more on the growth potential than the value gap. With a 17.9% return on invested capital, however, you can be sure that Oracle is creating plenty of value for shareholders. Perhaps this is the reason why Oppenheimer recently rated the stock an "outperform."

Cisco is in an even better position. At a quick ratio of 3.3x, it has plenty of cash to pursue accretive acquisitions. But the organic business has been doing just fine with better-than-expected performance in all of the last 5 quarters (an average beat of 7.9%). Despite all of the volatility, management has been able to hold margins relatively steady. Assuming Cisco meets expectations, it will be valued at $41.10 at a 15x multiple. Put differently, the company should be worth just north of $25.50 today at a 10% discount rate--around a 35% premium to the current market assessment.

Moreover, I like management's strategy on the future. The decision to acquire Meraki, a provider of cloud solutions to midmarket companies, for $1.2 billion represents a major catalyst capitalizing on technology transitions. Meraki offers WiFi, security appliances, mobile solutions, and access switches to over 18,000 customers across 145 different countries. To avoid maturity issues, Cisco has diversified beyond its core routers and switches market and into video, wireless, and security offerings. For this reason and the tremendous value gap, I encourage making an investment.


TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of International Business Machines and Oracle. Motley Fool newsletter services recommend 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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