When I last wrote about IBM (NYSE:IBM) in mid-April 2012, I thought that for all of the quality that IBM offered, the stock was still too expensive and vulnerable to a broader tech slowdown. The stock (and tech in general) dutifully cooperated, falling about 10% over that period. While IBM is not yet cheap enough to make it a hands-down buy, it is very much worth noting that not only is IBM now the model that many tech companies seem to aspire to, but it is also executing that model better than anybody else.
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Good Results in a Tougher Environment
Perhaps IBM didn't post exemplary results for the second quarter, but the company did a good job of managing a tough environment and still finding ways to improve margins.
Reported revenue fell 3% from last year, but rose 1% on a constant currency basis and rose about 5% from the first quarter - missing top-line estimates, but not by a large margin. Services saw 1% constant currency growth, while software grew 4% and hardware fell 7%.
Despite a tougher operating environment, IBM posted a GAAP gross margin improvement of better than one point and managed to grow operating income by about 1% (again, on a GAAP basis).
SEE: Understanding The Income Statement
Read-Throughs Suggest a Tough Market for Rivals
Looking at IBM's hardware numbers, it looks like Dell (Nasdaq:DELL) and Hewlett-Packard (NYSE:HPQ) both have their work cut out for them in the server market. While IBM also reported falling sales for mainframes, that number is so volatile that I would not read too much into it at this point. Looking at storage, though, it would appear that EMC (NYSE:EMC) is building its share lead as IBM and partner NetApp (Nasdaq:NTAP) appear more stagnant at present.
With IBM's middleware business up 4% this quarter, there's still some positive momentum in the space. That broadly fits with what we've heard from Oracle (Nasdaq:ORCL) not so long ago, but also does lay down something of a gauntlet for SAP (NYSE:SAP) and Microsoft (Nasdaq:MSFT) to keep up.
In services, IBM continues to see a relatively challenging spending environment. Signings were flat in constant currency terms, with backlog down slightly. While that's worse than, say, Infosys (Nasdaq:INFY), IBM management sounded more confident about the near-term trajectory of its business. Nevertheless, it does highlight that companies like HP and Dell likely have their work cut out to make a real splash in this sector.
Nobody Does IBM Like IBM
Looking at the moves that HP, Dell and even Oracle have made over the last couple of years, it seems pretty clear that there is ample interest in duplicating the IBM model - that is, a mix of hardware, software, and services for the IT market. Trouble is, nobody seems to be able to do the IBM model as well as IBM (although Oracle is doing just fine with its particular strategy).
At this point, I would expect that Dell, HP and even Microsoft still have M&A moves to make in order to appropriately reshape their businesses, and those deals carry risks not only in over-paying, but also integrating and growing the acquired businesses. IBM, though, arguably doesn't need to do much. I would not be stunned if the company decided to add a business or two within hardware, or perhaps augment its software with a market- or technology-driven deal here and there, but this company really doesn't need to do anything transformative.
SEE: Analyzing An Acquisition Announcement
The Bottom Line
I do believe that there are strategic advantages in IBM being able to hold a steady course while other tech companies are arguably still trying to decide what they want to be when they grow up. Nevertheless, I think IBM's size will make it difficult for the company to grow more than a few points faster than the overall market.
Consequently, I have difficulty seeing forward compound free cash flow growth much in excess of the mid-single-digits. With that sort of growth, and applying a somewhat favorable discount rate and adjusting for the balance sheet, fair value would seem to be in the low $200 area. That suggests enough potential to hang onto these shares, but perhaps not enough to make new commitments today.
At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.