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Why I Changed My Mind on This Tech Stock

InformationTechnology

In 2013, I knew IBM Corp. (IBM) was in big trouble.

IBM was one of the most widely held stocks in the world. It was a staple in every retirement portfolio. Even the world’s greatest investor, Warren Buffett, took a massive position in the stock.

It seemed like the perfect long-term investment. IBM looked cheap, the company was buying back stock and its above-average dividend was a great source of income for investors.

However, my analysis told me the stock was not cheap. Competitors were taking market share in some of IBM’s top businesses. This included its hardware and its services businesses.

IBM was generating nearly $100 billion in revenue in 2013. I knew there was little chance the company would grow sales based on these competitive threats. This sales decline would eventually lead to much lower profits — and likely a much lower share price.

In 2013, IBM generated $98.3 billion in sales and $16.5 billion in net income. Today, the company generates $86 billion in sales and $11.3 billion in net incomeThat amounts to a 13% decline in sales and a massive 31% decline in net income.

As you can see from the chart below, IBM significantly underperformed the market since 2013. Shares are down 12% — while the S&P 500 is up 47%.

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Today, IBM is a hated company.

Only three of the 17 sell-side analysts (like Goldman and JP Morgan) that cover IBM rate the stock a “Buy.” This bearish sentiment is surprising given that IBM trades at just 10 times earnings and sports a 3.3% yield.

Based on my analysis, most of the negatives are already factored-in to the stock. Plus, IBM has made positive changes to its business model that will begin to hit its bottom line starting in 2016.

That’s why I suggest buying IBM at current levels.

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The past three years have been terrible for IBM. The company’s sales and net income have been spiraling downward. This caused the stock price to significantly underperform the markets.

IBM’s hardware business (which accounts for almost 20% of sales) has been melting away. And recently, its global technology and business services divisions (which account for 60% of business) have been hurt by a strong U.S. dollar.

However, IBM has drastically changed its business model over the past few years. Management is now focusing on three key areas of growth. This includes:

1. Data (which IBM calls the new natural resource)

2. Cloud (one of the biggest game-changers in IT)

3. Engagement (as mobile and social media are transforming the way billions of people engage with each other)

Starting with Data …

IBM has over 15,000 consultants and 400 mathematicians on staff. The company invested over $26 billion in Big Data analytics including Watson, the world-famous artificially intelligent computer system capable of answering almost any question.

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Meet IBM’s Watson

The company has added over 500 analytical patents over the past few years. And over $1 billion has already been invested in Watson.

IBM says the market opportunity for analytics alone is $315 billion by 2018.

IBM has acquired 18 Cloud companies over the past few years and spent over $8 billion building out its cloud platform. This platform is used by 80% of the Fortune 500 companies. IBM plans on adding 46 data centers by the end of this year.

IBM says the market opportunity for Cloud is worth $400 billion by 2018.

Engagement includes mobile, social media and security. IBM recently signed a deal with tech giant Apple to sell iPhones and iPads to IBM customers. In return, Apple will use IBM’s cloud services and device management for all Apple devices.

IBM now has over 6,000 mobile specialists and over 2,800 social media specialists to better target these massive growth markets.

IBM says the market opportunity for Engagement is worth $290 billion by 2018.

To recap: IBM predicts Analytics (Big Data), Cloud and Engagement will have a combined market opportunity of over $1 trillion over the next three years. And the company has positioned itself to take advantage of these massive growth trends.

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IBM has also done a great job shedding non-core assets.

Last year, the company divested its microelectronics (chip) division for $1.5 billion. They sold their server business (x86) to Lenovo for $2.3 billion and their customer care division to Synnex for $505 million.

These were drags on the company.

IBM also cut thousands of employees (although the company will not disclose this number). This was mostly due to the 20%-plus decline in its system hardware segment which continues to struggle.

Looking at the bigger picture, IBM has spent the past three years transitioning itself from hardware / software into a data analytics / cloud / engagement company. These areas will see huge growth for decades to come.

It’s been a painful ride. But IBM’s strategic moves are about to hit the bottom line.

Turning to valuation, IBM now trades at just 10 times forward earningsThat’s a 45% discount to the market — including companies like McDonald’s (MCD) and Coca-Cola (KO) — which are also having trouble growing sales.

IBM saw an increase of its backlog to $122 billion. This is revenue the company plans on booking in the future. (Remember, IBM only generated $86 billion in revenue over the past 12 months.)

The company should generate $14 billion in free cash flow this year. Management said it will return about two-thirds of this cash to shareholders (in the form of buybacks and dividends).

Also, by investing in IBM, you can invest alongside one of the greatest value investors in the world.  Warren Buffett’s Berkshire Hathaway owns 79.5 million shares of IBM (worth $12.8B). That amounts to an 8.1% position, or one of Berkshire’s largest portfolio holdings.

Buffett’s average price paid for IBM (since 2012) is roughly $170 a share. Today, shares are trading below $160. In short, you can buy IBM today at a 7% discount to Warren Buffett.

Based on my research, IBM offers a great risk / reward for investors. Berkshire will likely continue buying shares at these super-cheap levels. IBM will also continue to purchase its own shares at these levels. Plus, the stock pays an enormous 3.3% yield — which is easily covered by earnings.

These factors alone should limit the potential downside in IBM. And if management is able to successfully transition itself from a deteriorating hardware company into a growth company again, the stock is likely to soar from these depressed levels.