IBM (IBM) is one of the oldest publicly traded technology corporations. The company was founded in 1911 and has grown to a value of $160 billion.  The company has not reduced its dividend payments since 1993; a streak of 21 consecutive years of dividend payments without a reduction. IBM’s impressive dividend streak makes it a member of the exclusive Dividend Achievers Index. The Dividend Achievers Index is made up of 238 stocks with 10 or more consecutive years of dividend increases.

IBM’s long history makes it a suitable candidate for long-term investors’portfolio. Warren Buffett has made it his third largest investment position, responsible for over 12% of his total portfolio. IBM stock looks cheap at this time (more on that later) with its P/E ratio of just 10.1 and its dividend yield of 2.7%.  Learn more about one of the oldest technology giants below.

Business Overview

IBM is a large multi-national corporation. The company divides its operations into 5 primary segments. The table below breaks IBM’s operations down by segment (data comes from first 9 months of IBM’s fiscal 2014).

Source:  Data from IBM’s Q3 2014 Report

IBM’s two largest segments based on pre-tax income are global technology and software. Together, these two segments have accounted for 76% of the company’s pre-tax income over the first 9 months of fiscal 2014.

The Global Technology Service segment provides IT infrastructure and business process services. The segment is further broken down into 5 divisions based on service provided:

• Strategic Outsourcing Services
• Global Process Services
• Integrated Technology Services
• Cloud Services
• Technology Support Services

The company’s Global Business Services segment provides consulting and application management services to customers. The segment is IBM’s third largest based on pre-tax income, responsible for 14% of total operating income for the company so far.

IBM’s Software segment has grown to become the company’s largest based on pre-tax income. The segment is further divided into 7 software divisions:

• WebSphere Software: allows organizations to run high-performance business applications.
• Information Management Software: enables clients to integrate and analyze ‘big data’
• Watson Solutions: first commercially available ‘big data’ cognitive computing platform
• Trivoli Software: controls and automates infrastructure and technology assets
• Social Workforce Solutions: enables businesses to connect people and processes
• Rational Software: helps support software development
• Mobile Software: offers customers true end-to-end mobile solutions

The company’s systems and technology segment is its only segment to generate pre-tax income losses through the first 9 months of fiscal 2014.  The segment is currently responsible for 12% if IBM’s total revenues. The segment provides customers with storage and computing hardware and services.

Finally, IBM’s Global Financing segment leases hardware to customers and finances customer payments for IBM’s other segments. The Global Finance segment has generated 10% of pre-tax income for IBM through the first 9 months of fiscal 2014.

Historical Growth & Current Earnings

IBM has grown its revenue per share at about 6.1% a year over the last decade.  The company’s EPS have grown at a much higher rate of 14% a year. Dividends have grown at a rate of 20.7% a year since 2005. Shareholders who purchased IBM at the beginning of 2005 now have a yield on cost of 4.6%. IBM has managed to grow EPS much faster than revenue by focusing on margin enhancements. The company grew net profit margin from 9.3% in 2005 to 16.5% in full fiscal 2013.

Strong performance over the last decade does not guarantee future success. IBM operates in the rapidly changing technology industry. The company has managed just 2% growth in adjusted EPS through the first 9 months of fiscal 2014 versus the same period a year ago.  Third quarter adjusted EPS fell 10% versus the same quarter a year ago. IBM CEO Ginni Rometty had this to say about third quarter 2014 results:

“We are disappointed in our performance. We saw a marked slowdown in September in client buying behavior, and our results also point to the unprecedented pace of change in our industry.”

Current Value, Competitive Advantage, & Future Shareholder Return

Weak third quarter results have depressed IBM’s share prices.  The company is currently trading for a P/E ratio of 10.1 and a forward P/E ratio of 9.6.  The company’s stock is down over 15% on the quarter, while the S&P 500 is up about 5% in the same time period. Using IBM’s 10 year EPS growth rate of 14%, the company has a PEG ratio of 0.72 and a dividend-adjusted PEG ratioof just 0.60.

IBM is one of the few businesses I have analyzed that has a long history of dividend growth in the rapidly changing technology industry (see ADP for one more).  IBM’s ability to adapt has allowed the company to survive over 100 years in an industry where rapid change causes competitive advantages to erode quickly.  IBM’s competitive advantage comes from its well-trusted and respected brand (admittedly odd for a company with a sordid past). In addition to its well trusted brands, IBM also has a large intellectual property portfolio which it uses to protect its advances from its research and development department. In total, IBM spent $6.2 billion, or 6.22% of revenues on research and development through its full fiscal 2013. There are very few companies that can match IBM’s multi-billion research and development budget and expertise.  The company’s focus on innovation and high margin businesses is another driver of its success.

In an effort to focus the company on higher margin business, IBM has elected to divest its lower margin x86 server business to Lenovo (LNVGY) for $2.3 billion in cash. The company is also divesting its unprofitable semiconductor manufacturing business to Global Foundries.  IBM will pay Global Foundries $1.5 billion to take the segment, as well as give the company access to some of its intellectual property.  In return, Global Foundries will become IBM’s exclusive semiconductor technology provider for 10 and 14 nanometer semiconductors for the next 10 years. These two divestitures position IBM for higher margins going forward and better focus the company on its core differentiator of high value research and development rather than manufacturing.

Going forward, Value Line analysts expect IBM to grow EPS at 7.5% a year over the next 3 to 5 years. Zacks investment research estimates 5 year EPS growth at 6.1%. These numbers are both well below the company’s historical EPS growth rate of 14%. A large driver of IBM’s growth over the past decade has been share repurchase. The company has decreased net share count by about 5% a year over the last decade. I believe IBM will grow EPS between 7% and 13% a year from organic revenue growth (2% to 5%), share repurchases (5%) and margin improvements (0% to 3%). At the median, this comes to 10% EPS growth. The various estimates in this article for IBM’s expected EPS growth are:

• Historical 10 Year EPS Growth: 14%
• Value Line: 7.5%
• Zacks: 6.1%
• Sure Dividend: 10%

Taking an average of the 4 estimates above, IBM’s future EPS growth rate is 9.4%. I believe this number gives the company credit for its past success while factoring in analysts future projections. If IBM delivers 9.4% EPS growth, shareholders will see a total return of 12.1% a year from EPS growth (9.4%) and dividends (2.7%).

Final Thoughts

IBM is clearly a high quality business. Warren Buffett making the company a core holding of his portfolio speaks volumes about the brand strength of IBM. The company has not reduced its dividend payments in 21 years, falling a few years short of Sure Dividend’s minimum requirement of 25 or more years of dividend payments without a reduction (the first rule of The 8 Rules of Dividend Investing). Nevertheless, IBM is a high quality business that appears to be undervalued.