Investing In IBM Stock - Is Warren Buffett Right To Hold The Big Blue?

  • IBM posted weak results in Q4 2014.
  • IBM forms one of the largest holdings of Warren Buffett.
  • A detailed IBM stock analysis to see if its right for your portfolio.

IBM (NYSE:IBM) is unique among technology corporations due to its long history. The company was founded in 1911, making IBM over 100 years old. Additionally, IBM has not reduced its dividend payments since 1993, giving it a streak of 22 years without a dividend reduction. Famous investor Warren Buffett has taken notice. Warren Buffett made IBM one of his largest holdings during the Great Recession of 2007 to 2009.  IBM is currently trading at a price-to-earnings ratio of just 10.4. Is IBM as right for your portfolio as it is for Warren Buffett's?

Business Overview

For a detailed IBM stock analysis, let's take a look at the company’s 5 primary operating segments, which are:  Global Technology Services, Global Business Services, Software, Systems & Technology, and Global Financing.  The percentage of total gross profit each segment generated is shown below to give an idea of the relative size and importance of each segment to IBM.  All data is from the company’s most recent 4th quarter earnings release.

  • Software: 48% of total company gross profit
  • Global Technology Services: 30% of total company gross profit
  • Global Business Services: 12% of total company gross profit
  • Systems & Technology: 8% of total company gross profit
  • Global Financing: 2% of total company gross profit

IBM’s most important segments based on gross profit are Software and Global Technology & Services. Together, these two segments account for 78% of the company’s gross profit.

Software Segment

IBM’s software segment is its largest business segment by a wide margin.  This one segment alone generated nearly half of the company’s gross profit in full fiscal 2014.  The software segment is further dividend into 7 operating divisions.  Each division is shown below along with a brief explanation of what it does.

  • WebSphere Software:  Allows organizations to run high-performance business applications.
  • Information Management Software:  Enables clients to integrate and analyze 'big data'
  • Watson Solutions:  First commercially available 'big data' cognitive computing platform
  • Trivoli Software:  Controls and automates infrastructure and technology assets
  • Social Workforce Solutions:  Enables businesses to connect people and processes
  • Rational Software:  Helps support software development
  • Mobile Software:  Offers customers true end-to-end mobile solutions

Despite being the company’s largest segment, sales and pre-tax income were down in the most recent 4th quarter. Revenue fell 7% while pre-tax income declined 11% in the segment. IBM claims to be  'repositioning' itself for better margins, but declining pre-tax income is never a positive sign. IBM is being outplayed by its competitors.

Global Technology Services Segment

The Global Technology Service segment provides IT infrastructure and business process services. Similarly the software segment and the global technology services segment is further divided into 5 divisions:

  • Strategic Outsourcing Services
  • Global Process Services
  • Integrated Technology Services
  • Cloud Services
  • Technology Support Services

The Global Technology Services Segment went through a restructuring in 2014. The company divested its customer care outsourcing business unit and its System X business. Accounting for these two adjustments, the segment appears to be flat on the year. The company’s backlog (adjusted for currency effects and divestitures) was flat in the 4th quarter of 2014 versus the same quarter a year ago.

Growth Prospects

IBM has compounded earnings-per-share at 12.4% a year over the last decade. The company's strong growth has been driven by focusing on higher margin business. Unfortunately, growth has slowed over the last several years.  Since 2011, IBM has grown earnings-per-share at under 5% a year. The company is losing ground to its competition in the rapidly evolving tech industry.

Looking ahead, IBM is not painting a pretty picture for 2015. The company had operating earnings per share of $16.53 in full fiscal 2014.  In 2015, IBM is expecting operating earnings per share of $15.75 to $16.50.  The company is expecting earnings to decline by around 2.5% in fiscal 2015.

Management’s long-term goal is to drive operating earnings per share growth in the ‘high single digits’; somewhere between 7% and 9% a year. The company is attempting to grow per share numbers through share repurchases. Over the last decade, IBM has repurchased an average of 5% of shares outstanding a year. This will provide significant tailwinds to IBM’s growth numbers. In addition to share repurchases, the company will have to organically grow earnings by between 2% and 4% a year to hit management’s long-term growth goals.

The bottom line for IBM’s growth is that it is very much in question. The company is transitioning to cloud based business and big data analysis. Analysts are having a difficult time determining the growth prospects of the company. If current results are any indication, growth at IBM is not going according to plan.

Valuation & Total Return

Due to weak results in 2014 and expected operating earnings declines in 2015, IBM is trading at a low price to earnings multiple of just 10.4. This is well below the company’s long-term average price-to-earnings ratio.  IBM looks significantly undervalued at these prices.

In addition to its low price-to-earnings ratio, IBM has a solid 2.7% dividend yield. If the company’s earnings decline at 2% a year, shareholders will still have total returns of between 5% and 6% a year from dividends (2.7%) and share repurchases (5%).

The real value in holding IBM shares is the chance the company will return to growth. If management can return the company to growth, investors will see large gains from a rise in IBM’s price-to-earnings ratio and earnings per share. Investors get paid to wait with the company’s 2.7% dividend yield.

Final Thoughts

Warren Buffett clearly thinks IBM is a high quality business, or he would not hold the company’s stock. IBM is suffering through a business transition and weak results at the moment, which has depressed the company’s share price. Despite the company’s low price-to-earnings ratio, I believe there are better investment options available for conservative investors looking for dividend income growth due to the risks that come with owning IBM stock.

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