On April 21, I wrote here that IBM’s (NYSE:IBM) stock was expensive — but it has since gained 4%. Late Monday, IBM came out with a quarterly earnings report that beat analyst’s expectations. The news pushed the stock 4.5% higher in recent Tuesday trading.
The question is, are IBM shares still pricey or have stronger financials brought about a more reasonable valuation?
IBM has changed its business mix over the last decade. In 2001, service and software accounted for 65% of sales, and they now account for 80%.
Looking ahead to 2015, IBM wants to raise operating earnings to $20 a share. To do that, IBM is investing in cloud (web-based) computing and analytics software – predicting the two will generate $7 billion and $16 billion in revenue, respectively, by 2015. IBM expects its Smarter Planet plan to digitize power grids and roads — will add $20 billion in sales through 2015. IBM also wants to boost sales to Brazil, China and India above the 21% of overall revenue it generated in 2010..
These results and plans all sound good, and here are two other reasons to consider investing in the stock:
- Great earnings reports.IBM has been able to beat analysts’ expectations consistently and has done so in all of its past six earnings reports.
- Decent dividend yield. IBM’s annual dividend of 75 cents a share offers a yield of 1.7%.
- Out-earning its cost of capital. IBM is earning more than its cost of capital at a faster rate. IBM’s EVA momentum, which measures the change in “economic value added” (essentially, profit after deducting capital costs) divided by sales was 2%, based on the company’s first six months’ 2010 annualized revenue of $93.2 billion, and EVA that rose from $3.2 billion annualizing the first six months of 2010 to $5 billion annualizing the first six months of 2011, using a 10% weighted average cost of capital.
But there are two reasons to consider avoiding IBM stock:
- Its stock price is still highly valued. IBM’s price-to-earnings-to-growth of 1.38 (where a PEG of 1.0 is considered fairly priced) means it is an expensive buy. IBM currently has a P/E ratio of 14.72 and is expected to grow about 10.6% to $14.62 a share in 2012.
- Good long-term profit growth but riskier balance sheet. IBM continues to show strong growth. Its revenue has increased at an average rate of 1.9% over the last five years, and its net income of $15.4 billion has risen at a 13.2% annual rate over that period. And its cash has grown slightly at a 2.3% annual rate from $10.7 billion (2006) to $11.7 billion (2010), while its debt has spiked at a 12.1% annual rate from $13.8 billion (2006) to $21.8 billion. This high debt level ranks it in last place compared to the other companies in the industry, and its debt-to-equity ratio of 1.33 is also the worst in the industry.
IBM is doing a solid job of managing to boost the earnings growth of a very large company, but the problem it faces is that it is very difficult to come up with new ideas that will move the revenue growth needle enough to make a difference. At its current valuation, IBM stock could creep higher – and it would likely survive an economic downturn better than its smaller peers as long as its rising debt levels do not bite into its cash flow too much.
I think IBM stock is a good place for some of your money, just not the part that you want to see grow.
Peter Cohan has no financial interest in the securities mentioned.