Is There Value In IBM And Microsoft?

We are happy to see folks refocus their gaze on undervalued stocks with heretofore out-of-favor companies finding the spotlight while formerly high-flying names like Netflix and Alphabet ( Google ) pull back in response to earnings reports that were not as good as the optimists had expected. No guarantees, of course, that Value continues to outperform, and we know that some sort of a pullback after the grand advance would not be unreasonable, but we very much like the fact that our broadly diversified portfolios sport valuation multiples below and dividend yields above those of the major market averages as well as most of the Value benchmarks.

Despite the rally, we believe that a lot of bad news had been priced into equities. After all, it isn’t every day that dividend yields on stocks exceed yields on longer-term U.S. Treasuries. And, happily, such is still the case this week (4.22.16), as the S&P 500 now yields 2.16%, compared to a 1.35% yield on the 5-Year Treasury and a 1.87% yield on the 10-Year Treasury. Throw in the fact that the historical odds show a strong likelihood for gains on Value stocks over 5- and 10-year time spans, and we think that those who share our long-term time horizon should remain optimistic about the prospects for their portfolios.

The health of corporate profits remains critical to stocks, and decent first quarter earnings reports have provided a boost to the markets over the last two weeks. While top-line growth has been uninspiring and forward guidance has been cautious, investors were evidently expecting results to be weaker as Bloomberg calculates that of the 132 S&P 500 members to have announced first quarter numbers thus far, 76.5% (101) have turned in EPS that exceeded analyst expectations, 9.1% (12) met forecasts and 14.4% (19) lagged consensus projections. This compares to Beat/Match/Miss percentages of 67.7%/9.8%/22.4% for the entire first quarter of 2015.

Global provider of computer solutions and advanced technologies leader Int'l Business Machines posted earnings per share of $2.35, versus the $2.09 estimate in Q1 2016. IBM had sales of $18.7 billion, versus the $18.3 billion estimate. Shares tumbled 5.6% following the announcement. A strong U.S. dollar and cyclical challenges were the primary detractors to IBM's recent performance, and tax benefits accounted for roughly half of the firm's earnings in the quarter.   CFO Martin Schroeter said of the outlook, "As we look at the second quarter, we typically see a profit improvement from first to second quarter. In fact, last year, it was $1 billion increase in pre-tax income. This year, we expect more given the significant charges in our first quarter, but we'll also have an impact from the acquisition ramp and quarter-to-quarter impact from currency hedges. Put it all together and we see about a $2 billion increase in pre-tax profit from first to second quarter. With our anticipated tax rate and our share repurchase, at that profit level we'd achieve between 38% and 39% of the $13.50 of earnings per share by the end of the first half."

While we understand the worries, particularly the currency headwinds, we like that that IBM has divested non-core operations and that the company continues to see strong growth from many of its newer segments. According to the company, strategic imperatives delivered $30 billion in revenue over the last year, which translates to 37% of revenue. IBM trades for under 11 times forward earnings per share, while the company has $4.7 billion remaining on the current share repurchase plan. With the yield now up to 3.5%, we continue to find IBM to be quite undervalued.

Computing giant Microsoft reported earnings per share of $0.62, versus the $0.64 estimate in fiscal Q3 2016. MSFT had revenue of $22.1 billion, versus the $22.1 billion estimate. Adoption of the Windows 10 operating system has been strong, with 270 million devices running the software, and enterprise cloud computing exceeded $10 billion of revenue run rate. MSFT has a revenue target for the latter of $20 billion by 2018.   Microsoft CFO Amy Hood said, “This year we saw strong growth in our commercial cloud portfolio, and we grew our annuity penetration across our commercial business. We anticipate those trends will continue next fiscal year, driving our revenue growth and impacting our gross margin percentages. As we continue to unify and modernize our Windows installed base across our consumer and business customers, we will advance our progress in our post-sale monetization scenarios and execute on the Windows 10 enterprise deployment opportunity.”

All sounds fairly positive, but the stock tumbled more than 7% in the wake of the results due to the bottom-line miss and soft guidance for revenue in the current quarter. We have trimmed our Target Price, but we continue to like the great number of platforms that are integrated into Azure, MSFT's cloud computing platform, and are pleased that cloud revenue continues on its impressive growth trajectory. We also like the solid dividend yield near 2.8% and the terrific balance sheet, so we expect to continue to hold this high-quality name for a while longer.

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Opinions expressed are those of John Buckingham, Chief Investment Officer of Al Frank Asset Management, a division of AFAM Capital, Inc. and editor of The Prudent Speculator newsletter.

171-AFAM-4/26/2016