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Why IBM Is Now An Undervalued Long-Term Investment Play

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This article is more than 9 years old.

By now Wall Street is singing the blues on Big Blue. Almost all analysts who follow International Business Machines (IBM) are down on the once Master of the Tech Universe. And sadly for the bluest of the Blue bulls, one of Wall Street’s erstwhile darlings has become a stock to spurn.

The reason: The giant has stumbled and by most accounts, struggling to make it back to solid ground. The once high-flying stock has tumbled more than 20% in the past six months, collapsing close to its 52-week low of $150.50 a share -- down from its 52-week high of nearly $200. However, not a few daring contrarians have since snapped up IBM shares, pushing the stock up some, to $156.24 at the market’s close on Friday, Jan. 22, 2014.

These opportunistic long-term value players who scooped up shares as they were falling may be on to something that the Street ignores or belittles.

The big knock on Big Blue is that it faces sub-par growth ahead as pressure on earnings mounts, making its badly needed turnaround a big challenge, if not a remote dream – for at least one to two years.

“IBM still has a steep climb ahead,” cautions Societe Generale analyst Richard Nguyen, who rates the stock as a sell. “We remain cautious on the stock as we think the transformation plan to reposition IBM in a cloud-based environment could take time to deliver,” he says. And the stock, he contends, currently has a "relatively rich valuation” compared to IBM’s peers. And foreign exchange volatility and “continued secular pressures limit visibility into an earnings-per-share and free cash-flow recovery,” says Katy L. Huberty, analyst at Morgan Stanley, who rates IBM as “equal weight” but nonetheless has raised her price target for IBM to $159 a share from $154.

There are undoubtedly significant fundamental positives that are driving guarded optimism among some investors and traders, including previous IBM skeptics.

Insightful equity analyst Scott Kessler of S&P Capital IQ upgraded a week ago his recommendation on IBM to a buy from a hold after the company reported fourth quarter results, which other analysts had found disappointing. But Kessler believes IBM’s “diverse business model offers appeal” even as he foresees continuing difficulties while IBM adjusts its portfolio of offerings, particularly within the hardware business.

Kessler is also concerned about IBM’s ability to compete in a fast-changing IT market. “Nonetheless, we see progress as to its strategic imperatives, considerable stock buyback actions, and a recent indicated dividend yield of 2.9%,” says Kessler.

His 12-month price target of $175 a share reflects a weighting of price-earnings and P/E-to-growth comparisons to the 2015 P/E of S&P 1500 Information Technology sector index, according to the analyst, who notes that IBM recently traded at a depressed 2015 P/E below 10 times. S&P forecasts IBM revenue will drop 8% in 2015 after falling 7% in 2014, in part due to weakness in the systems and technology segment, reflecting multiple issues, including a cyclical decline in the mainframe business and weak sales in China and some emerging markets.

But “we see cloud, analytics, mobile, social and security as growth opportunities and believe IBM has been executing relatively well in these areas, called strategic imperatives, which accounted for 27% of 2014 revenues,” says Kessler. One big plus is that annual gross margins, notes Kessler, have been trending higher despite the lack of revenue growth. And “we see continuing improvement reflecting a more favorable revenue mix. Cost-cutting efforts, including work force realignments, and productivity gains, says Kessler, should aid 2015 and 2016 EBIT (earnings before interest and taxes) margins.

Kessler projects IBM will earn $16.02 a share in 2015 and $16.60 in 2016, aided by considerable stock repurchases, up from 2014’s $15.59. IBM has evolved from being a computer hardware vendor to a systems services and software company, focusing on integrated solutions. IBM is now focusing on “higher value-added segments," notes Kessler, such as services at over 61% of 2014 sales, and software at 28%. And IBM is using global financing, he adds, to primarily expand its customer base and to leverage IBM’s financial structuring and portfolio management.

Peter Wahlstrom, equity analyst at Morningstar, points out that “everyone should grasp that IBM is a company in transition,” and that investors shouldn’t have been surprised by IBM’s fourth quarter results. He notes that “management had framed its perspective well last October when it missed expectations and pulled its fiscal 2015 adjusted earnings target.” There are some early positive signs, he says, but there’s plenty of uncertainty as well. He expects to update his long-term assumptions after IBM’s Analyst Day meeting scheduled for February.

Meanwhile, there are analysts on the Street who aren’t overly concerned about the outlook that IBM provided when it reported its fourth quarter results. “IBM provided a 2015 earnings outlook that we can live with and one that straddles our earnings-per-share projection,” says Brian J. White, analyst at investment firm Cantor Fitzgerald, who rates IBM as a buy with a 12-month price target of $198 a share.

Although IBM is experiencing near-term challenges, IBM has grown earnings-per-share by 15% a year between 2007 and 2013, versus 10% growth for the S&P 500 index, notes White. His price target of $198 a share is based on his earnings forecast of $16.51 a share, up from his projected 2015 estimate of $15.85.

Are IBM's sales and earnings close to hitting a trough? White thinks so. "Our current model reflects a bottom in the sales cycle and operating profit cycle during the fourth quarter of 2014," says White. Given IBM's fine-tuning of the portfolio through divestitures, restructuring initiaves and investment in next-generation IT, "we believe the company is positioning itself for better trends in 2016," asserts White.

So with signs that "IBM's profit cycle has bottomed and the stock is now trading at 9.5 times our 2016 earnings estimate and sporting a 2.8% dividend yield, we believe value investors may become more interested in IBM," argues the analyst.