International Business Machines (IBM) Analysis - Oct 2014

Category - Slow grower
Revenue is likely to stay flat in coming years.

Business characteristics
  • The technology (both software and hardware) sector is marked by a constantly changing arena, IBM will need to adapt to changes in addition to fighting competition. 
  • IBM's strategy is to adapt to changes in the tech arena by getting out of lower-end business and making a foray into software and higher-value services with a focus on cost reduction through acquisitions. 
About
Its in the enterprise software, services and hardware business and is an industry leader in each of its businesses. 

In the early 1990s, IBM started moving away from its reliance on mainframes towards software and higher-value services with a focus on cost reduction. 

The company creates business value for clients and solves business problems through integrated solutions that leverage information technology and deep knowledge of business processes. IBM solutions typically create value by reducing a client's operational costs or by enabling new capabilities that generate revenue.

IBM has a significant global presence, operating in more than 175 countries, with an increasingly broad-based geographic distribution of revenue.

The company continues to invest to capture the long-term opportunity in markets around the world that have market growth rates greater than the global average—countries within Southeast Asia, Eastern Europe, the Middle East and Latin America.

The company's major markets include the G7 countries of Canada, France, Germany, Italy, Japan, the United States (U.S.) and the United Kingdom (UK) plus Austria, the Bahamas, Belgium, the Caribbean region, Cyprus, Denmark, Finland, Greece, Iceland, Ireland, Israel, Malta, the Netherlands, Norway, Portugal, Spain, Sweden and Switzerland.

In 2013, IBM was awarded more U.S. patents than any other company for the 21st consecutive year.
Revenue
  • System hardware - 14% 
  • Infrastructure software - 25% 
  • Outsourcing and Systems integration - 60%. 
Competitive advantages
  • Software and services business has a high switching cost. 
  • Sticky - Reoccurring revenue stream. 
    • As an example, migrating mainframe based application to alternative architecture can be expensive and risky. 
    • When considering infrastructure-management software, IT personnel rely on it to operate their data centres and are reluctant to switch to new, less familiar systems. 
Threats
  • Cloud computing (Hardware): With computer resources increasingly delivered by cloud providers, demand for IMB's high-end servers could weaken. 
  • Cloud computing (Software): As software-as-a-service gains wider adoption, demand of IBM software could weaken. 
Competition
  • IBM is facing increasingly competitive pressure from Oracle and Cisco in hardware segment from commodity x-86-based servers. 
  • Custom software development approach being challenged by Oracle's cheaper integrated solutions that aims to meet 80% of customer requirements. 
  • Big data is a hot and growing industry with fierce competition. 
Shareholder return
Dividends: The company has increased dividends for 19 years in a row. The current payout ratio is 25%.

News 
  • IBM has shed roughly $7 billion in low-margin revenue through its recent divestitures of its customer care, System X and microelectronics businesses. 
  • The company sees weaker demand profile and plans to restructure of its workforce. 
  • Apple and IBM announced an exclusive partnership to further promote and deliver iOS to the enterprise customer with IBM developing and selling big data and analytics apps for the iOS platform. 
Growth
  • Mainframe markets is unlikely to grow, but will continue to provide steady flow profits. 
  • Revenue growth is likely to stay flat in coming years.
Earnings growth (absolute)

In order to arrive at the owner's earnings, the cash based 'R&D' expenses and non-cash 'Depreciation, Depletion and Amortisation' expenses have been added to the reported Net Income.

The table below shows the earnings in the last 10 years.


In the last 10 years, the absolute earnings have increased at an average of 4.19% and at a CAGR of 4.12%, which puts it in under 'Slow growers' category.

Due to the effect of share buybacks, the EPS on the other hand has grown at an respectable average of 14.78% and at a CAGR of 16.61%.


Earnings vs Expenditure
In the last 10 years, IBM has spent an average of 48% of its owners earnings on 'R&D', 'Property, Plant and Equipment' and 'Purchase of business'.

I would like to explain my rational behind treating 'R&D' as an expenditure. As a general rule of thumb, the accounting standards dictate that companies aren't allowed to capitalise their research and development cost and is instead treated as an expense which is in contrast to how the cost on 'Property, Plant and Equipment' is treated. The main reason behind it is that there's no way to reliably measure the future economic benefits of R&D costs. 

However, companies invest in R&D for the same reason as they invest in other capital expenditure - to grow/expand the business and remain profitable. Hence, in my analysis I add the 'R&D' expenses and other capital expenditure to arrive at owners earnings. Subsequently, I deduct any cost spent on 'R&D', 'Property, Plant and Equipment' and 'Purchase of business' as capital expenditure.

The graph below outlines the 'Earnings vs Expense' ratio in the last 10 years.


Dividends
IBM has increased dividends for 18 years in a row, which satisfies one of my investment criteria.

The graph below outlines the dividend growth rates in the last 10 years.

In the last 10 years, the dividends have increase at an average of 15.15% and at a fantastic CAGR of 14.78%. Due to the effect of share buybacks, dividend per shares on the other hand has grown at an average of 20.76% and at an extraordinary CAGR of 20.32%. A CAGR of 20.32 implies, dividends doubling evert 3.5 years.


Share buybacks
The graph below outlines the total amount of money IBM has spent on buybacks.
IBM has been able to manage to bring down the total number of outstanding shares (diluted) from 1,707.2 million in 2004 to 1005.1 million in 2014, thereby reducing the total outstanding shares by whooping 41%.

This demonstrates the management's focus on creating value for the shareholders.

Total shareholder value
The graph below outlines the total amount IBM has returned back to shareholders in the last 10 years through dividends and share re-purchases.

On an average IBM has been able to return 50% of its total owner's earnings to shareholders through dividends and share buy backs.

Financial strength (Balance sheet)
The total liability to earnings after capital expenditure is 6.24 which is phenomenal.

Long term outlook
IBMs strategy is to focus on
  • Big Data: The company has invested more than $22 billion, including $15 billion on more than 30 acquisitions, to build its capabilities in big data and analytics. 
  • Cloud computing: The company has invested over $6 billion to acquire more than 15 companies related to cloud, and is investing more than $1 billion to expand its global footprint to 40 datacenters worldwide. IBM now has more than 100 SaaS offerings, and IBM cloud supports 24 of the top 25 Fortune 500 companies. 
  • Systems of engagement: IBM has acquired 20 companies related to mobile, social and security. IBMers are collaborating in more than 200,000 internal social communities and 85 percent of IBM's sellers use the company's Sales Connect portal. 
Risks
Acquisitions, Alliances and Dispositions include Integration Challenges, Failure to Achieve Objectives, and the Assumption of Liabilities. Acquisitions often (two-thirds) fail to deliver the financial benefits that are envisaged.

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