International Business Machines (NYSE:IBM)     November 10, 2009 Analysts: Herman Klinger & Dean Brown 

              

  

Company Profile International Business Machines Corporation (IBM) develops and manufactures information technology products and services worldwide. Its Global Technology Services segment offers IT infrastructure and business process services, such as strategic outsourcing, integrated technology, business transformation outsourcing, and maintenance. The company’s Global Business Services segment provides professional services and application outsourcing services, including consulting and systems integration, and application management. Its Systems and Technology segment offers computing and storage solutions, including servers, disk and tape storage systems and software, semiconductor technology and products, packaging solutions, engineering and technology services, and retail store solutions. IBM’s Software segment primarily offers middleware and operating systems software comprising WebSphere software for Web-enabled applications; information management software for database, content management, information integration and

business intelligence; Tivoli software for infrastructure management, including security and storage management; Lotus software for collaboration, messaging, and social networking; and

STOCK DATA Price:  $121.29  

52‐Week H/L:  $69.50‐128.61 

Avg Vol (3m):  6,671,060 Market Cap:  159.33 Bil 

Float:  1.31 Bil P/E (ttm):  12.45x 

EPS (ttm):  $9.71  Dividend:  $0.55/qtr 

Yield:  1.81% 

Forward PE:  11.12x PEG:  1.92 

YPEG:  1.112 Sector:  Info Tech 

Industry:  Computers & Peripherals 

rational software, a process automation tool. The company’s Global Financing segment provides commercial financing to dealers and remarketers of IT products; lease and loan financing to external and internal clients; and sale and lease of used equipment. IBM serves banking, insurance, education, government, healthcare, life sciences, aerospace and defense, automotive, chemical and petroleum, electronics, distribution, telecommunications, media and entertainment, and energy and utilities, as well as small and medium sized business. The company was formerly known as Computing-Tabulating-Recording Co. and changed its name to International Business Machines Corporation in 1924. IBM was founded in 1910 and is based in Armonk, New York. __________________ Yahoo.com

 Valuation In order to value IBM, we decided to use a DCF model. We incorporated a margin of safety into our model by using a conservative annual EPS growth rate of 7.5% over the next 5 years (2% below estimates) and a growth rate of 3% from year 6 to perpetuity. We used the (ttm) EPS of $9.71 and discount rate of 11% which is the approximate historical yearly return on the S&P 500. Discount Rate: % Year Earnings Pres Val.

1

2

3

4

5

6 . . .

6 onward @ % annual growth rate:

Total: Based on the above, we have reached a price target of $151. This target is $9 below Standard and Poor’s price target of $160 (updated 10/16), but $11 above the median range given by analysts on yahoo.com. We believe that our price target is above the streets median range because most of the analysts used in yahoo’s survey have not updated their targets to incorporated quarter ended 9/30/2009. While sales fell short of estimates, IBM still beat estimates on the bottom line with EPS of $2.40, an 18% increase over the year prior. On top of this, on October 27th IBM announced that they will be putting some of their $9.5 billion in cash to work for the shareholders by more than doubling their stock buyback program funds to a total of $9.2 billion available. We see this as a very positive sign the company believes they are still undervalued as well as a great way to increase their EPS numbers in the

future. Finally, also on the 27th of October, the board also declared a dividend of $0.55 per share, payable to shareholders of record on November 10th. Unfortunately, we will miss the dividend payment by one day should we move into IBM after our next class. Where does this company make its money?  IBM is one of the largest IT solutions providers in the world. It designs computer systems and software and provides related services. The company's hardware products (19% of sales) include servers, storage systems, and electronic subsystems. IBM is also a leader in software (21% of sales), which enables disparate computer applications to communicate. IBM also offers an array of services (57% of sales), including outsourcing, maintenance, and systems integration. _________ Morningstar 

  Earnings Trends  EPS past 4 years by qtr:

*etrade.com

IBM has continued to show EPS growth over the last 4 years and have not reported a quarter below analyst estimates over that timeframe. We see no reason for any deviation from this trend and look for EPS growth to continue into the future. As the below graph shows, revenues are not increasing as fast as EPS, but by buying back bulks of shares and increasing gross margins to over 45% IBM has been able to sustain growth over the previous years and should continue to do so over our time with OFG.

Revenue past 4 years by qtr:

*etrade.com IBM’s revenue growth has been one dark spot where we are concerned. While it should not be a problem for our time in OFG, a longer term investor may want to be weary if revenues do not pick up as we exit the recession. During the early 2000’s IBM was gobbling up many smaller companies in order to push revenue growth. With the recent slowdown in the last 2 years, the company has dramatically pulled back on acquisitions and has only made one $300 million purchase since mid July of 2008. As we continue to pull out of the tough economic times, we are looking for IBM to use some of their cash and start buying synergistic companies in order to ramp revenue growth into the future. Management & Business Model  IBM management is led by CEO Samuel J. Palmisano, and is tops in the industry. Mr. Palmisano has been with IBM since 1973 and as you can imagine has worked in a vast range of functions for the company including COO, President, Group executive for IBM’s Enterprise Systems Group, IBM Global Services, and IBM’s Personal Systems Group. The company's business model is built to support two principal goals: helping clients succeed in delivering business value by becoming more innovative, efficient and competitive through the use of business insight and information technology (IT)

solutions; and, providing long-term value to shareholders. The business model has been developed over time through strategic investments in capabilities and technologies that have the best long-term growth and profitability prospects based on the value they deliver to clients. The company's strategy is to focus on the high-growth, high-value segments of the IT industry. Price Chart vs. Peers  

 

Source: www.finance.yahoo.com 

 

Industry Comparisons 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Source: http://moneycentral.msn.com 

 

 

 

 

 

Source: http://www.smartmoney.com 

 

 

 

Source: http://morningstar.com 

 

 

Source: Bloomberg 

 

 

Source: IBM 2008 Annual Report 

 

 

Source: Morningstar 

IBM share price has outperformed its industry, the S&P 500, the NASDAQ, and the DJIA YTD. Although revenues were down 6.9%, IBM’s net income was up 67%, while its industries average was up 29% and the S&P500’s was down 2.3% YTD. IBM’s gross profit margins were 45.6%, while the industry average was 37.2% and the S&P500’s average stood at 36%. Profit margin helped drive net income and have been increasing ever since 1999. The company has also decreased its COGS expense as a percentage of sales. IBM has outperformed its industry and the S&P500 when comparing their respective ROE, ROA, ROC, ROE 5 year average, ROA 5 year average, and ROC 5 year average. The company’s revenue is diversified across many global markets with a variety of IT services and products. IBM provides higher dividends to its shareholder relative to its industry and the S&P 500.

3rd Quarter Earnings Call 

IBM CFO Mark Loughridge reported:

1) The third quarter was driven by strong profit performers in software and services, and share gains in both hardware and software. This is the 20th quarter of the last 21 that IBM has expanded its gross margin.

2) IBM generated $3.4 billion in free cash flow, up almost $1.3 billion year to year and ended the quarter with $11.5 billion of cash on hand, while reducing the debt by $4 billion since June. The increase in cash was driven by higher net income and improved cash from sales cycle working capital, as collections remain strong and inventory low.

3) IBM expects about $3.5 billion of cost and expense savings this year. They have a spend base of almost $90 billion to work with, so there is room for more cost efficiencies.

4) IBM is using their strong profits and cash generation to invest in new market opportunities such as business analytics, smarter planet initiatives, and cloud computing.

5) Growth markets were down 1%, though China had great performance, up 26%. Overall the growth markets delivered 19% of IBM’s geographic revenue in the quarter and outpaced the majors by 5 points of growth.

6) Public sector was the fasting growing sector of business for IBM, led by healthcare and education.

7) IBM continues to shift to higher value added products, specifically with software, which contributed to almost 1/3rd of the profit margin improvement.

8) Items that hurt profit growth: Investment Transactions, a year to year impact of $100 million and interest income, which was down almost $70 million year to year, reflecting the current interest rate environment.

9) Backlog at the end of the quarter was an estimated $134 billion, that’s up almost $3 billion since 2nd quarter and $5 billion year to year.

10) “If you now turn to EPS guidance for Q4, I guess the first point I would make is that we took that guidance up now from $9.70 to $9.85, that’s out third increase this year and I think it indicates the confidence we have.”- IBM CFO. He continually emphasized throughout the call that this earnings estimate is the ABSOLUTE MINIMUM IBM expects to earn for the full year.

11) Analyst Question: What do you plan to do with your cash right now?

CFO Response: Drive investments in the IBM businesses, continue operational cadence on acquisitions which has very strong benefit for us, and repatriate value to our shareholders through both share repurchase and dividends.

Overall Analysis

IBM’s reported a blow out Q3 EPS even while revenues were down 7%. Revenues still were certainly an improvement from the double digit declines in the first half of the year. There is weak near term revenue growth and this is a concern that we have, but IBM has increased its bottom line by increasing profit margins and share repurchases. IBM will continue to increase profit margins as it focuses more on higher value added products and services. The company has aggressively cost cuts throughout the last 2 years, and adjusted its workforce to lower cost locations. IBM is efficient, which is difficult for many multinational corporations, and is exposed to many global markets with a variety of high value added products and services. IBM has a wide economic moat

and has done a good job of boosting profitability by streamlining operations globally. They have been awarded the most patents in the US for 16 straight years, and generate about $1 billion per year in intellectual property. IBM has built a reputation for successfully delivering complex solutions and has positioned itself well with plenty of cash for strategic acquisitions across many global markets, including the emerging markets. Our current price target for IBM stands at $151, a 22.28% premium over its current price.