IBM: Ignore the Lack of Upside
Steven is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
International Business Machines (NYSE: IBM) recently reported second quarter earnings and shares have reacted positively. The pulse of business at IBM appears stronger than what short-term investors have feared. Well, not necessarily strong, just more positive than expectations. “Less than feared = probably good” applies here, although I’m still trying to figure that market mystery out.
On the profitability side, IBM beat earnings expectations by $0.09, but revenues were off 3% from a year earlier. Also noteworthy is that the cost cutting will continue, with full-year 2012 EPS guidance being raised to $15.10, or by about 7%. Each penny per share IBM earns equates to about $11.5 million more in profit. A penny saved is $11.5 million earned – IBM has taken Ben Franklin’s approach to a whole new level. Speaking of pennies, IBM’s Free Cash Flow (FCF) increased 9% more than last year, generating a healthy $3.7 billion that has “potential reinvestment” written all over it.
The big picture takeaway depicts a company where revenues have softened and profitability has risen from aggressive cost cutting and share repurchases. Does this scenario make IBM the type of company worth getting involved with at this time? I’ll go through some factors to help answer this question.
Valuation
Estimating a correct growth rate is the hardest part to figure here. It’s unfortunately more subjective than I would prefer. If I get conservative and use a historically low rate of 3% or 6%, it will put IBM’s fair value between $143-164 per share. This seems a bit low, considering where IBM is trading today and its track record of growth. If I get more aggressive and use a rate of 11% (what they grew this quarter), the price target increases to $210. While entirely possible, that rate seems a bit high to sustain over a longer period of time. More than likely, the truth is somewhere in the middle, making an 8.5% rate seem reasonable. This changes the price target to $187. But you can see how much the price target shifts from one estimate to the next.
It’s important to keep your emotions out of this process, especially if you love a company. It’s a four letter word that will skew your perspective. It would be like having a pair of beer goggles on while evaluating stocks. This is somewhat of a rinse and repeat process, but I feel comfortable with a price target range of $187-210 – for now. It’s always possible I may change my estimates should I uncover new details, and this would change everything yet again.
Looking further, IBM shares trades at a discount relative to peers, yet the company’s profitability growth is much higher in comparison. Is this a gift from the investment gods? Perhaps, but it could be as simple as IBM being worth much more than its peers. Currently weighing in at $225 billion makes IBM the heavyweight top dog who is sitting on its tail. In other words, it takes a whole lot more capital to push IBM’s net worth higher than the competition.
Share Catalysts
Regarded by many as one of the most innovative companies on the planet, IBM invents their own catalysts. Take Watson for example and think about how disruptive this technology will become. It’s the definition of game changer. Picture a supercomputer that understands language with the help of Nuance Technologies’ (NASDAQ: NUAN) voice recognition software. Language by nature is very difficult for computers to understand due to its implicit, often imprecise nature. IBM has developed a way for a computer to comprehend the difference between liking someone and liking someone. And this is just the beginning.
Already Watson has defeated the best of the best in Jeopardy – the de facto game of nuanced language. And it did so without being connected to the internet. In a few years time it will diagnose disease, approve insurance claims, make financial decisions, and run call centers – all without breaking a sweat. The applications will be nearly endless, putting lots of jobs at risk.
On one end, Watson will push society forward with giant leaps in productivity. On the other, these gains will become the next big reason for massive layoffs. It has the potential to change the job market forever. Corporations with lots of low critical thinking jobs will put their staff on notice once Watson enters the workforce. It’s easy to see McDonald’s (NYSE: MCD) adding Watson to their menu because they’ve already started to experiment with robots. You want fries with that?
It’s not all doom and gloom for this workforce. Greater access to technology has allowed for more open access to education. The workforce at risk has the ability to reeducate themselves through services like Apple’s (NASDAQ: AAPL) iTunes U. Of course, it’s never that simple of a solution and it won’t happen right away. But at the very least, there is an option with a low barrier of entry to learn a new skill. All you need is access to the internet, the ability to install iTunes, and the will to learn.
Bottom Line
IBM is a business that has many different facets to it and I have only scratched the surface. They are much more complicated than slapping on a valuation and seeing if that price target makes it a buy. If I only looked only at valuation alone, I would overlook the potential this company has to change the world. It’s practically impossible for me to really know how much Watson will affect growth. And that’s where I think the opportunity lies – no one really knows. If Watson brings in 25% earnings growth, IBM will break $300 in no time.
With more certainty, I can count on Watson creating a world where business dynamics have changed drastically. The companies who don’t employ Watson run a real risk of becoming dinosaurs. For IBM, this is a great place to be and the market is wide open.
TopDownTrends owns shares of Nuance Communications. The Motley Fool owns shares of Apple, International Business Machines, and McDonald's. Motley Fool newsletter services recommend Apple, McDonald's, and Nuance Communications. 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.
