A "Prudent" Play on Big Blue

06/23/2006 12:00 am EST

Focus:

John Buckingham

Editor, The Prudent Speculator

When it comes to long-term investing, few compare to John Buckingham. While not for the short term orientedhis average holding period is five yearsThe Prudent Speculator ranks among the best in the advisory world. Here’s his latest on Big Blue.

"Although Hewlett Packard is expected to surpass International Business Machines (IBM NYSE) as the largest tech company in the world based on trailing revenue at the end of this quarter, we continue to praise IBM's efforts. The company has been increasing the overall profitability of the company by focusing on higher margin businesses, which has helped HP get to the top that much more quickly, even as the latter has reignited overall growth.

"Incorporated in New York in 1911, IBM is now the fourth-largest listed technology company in terms of market capitalization, at just under $122 billion. However, in our opinion, IBM is more attractive than it has been since 1998, trading at a trailing P/E of 14. Big is often bad in tech and IBM has been seeking to shed some of its bigness in order to focus on profitability. That process has so far resulted in the divestiture of three major business lines. Most recently, IBM sold its PC business to China-based Lenovo. Prior to Lenovo's acquisition of the PC segment, IBM exited two other commodity businesses: hard drives and displays.

"That leaves the company sitting atop a three-legged stool, with the services, hardware, and software businesses just about evenly supporting its overall weight. Sounds a bit like HP, no? Yes. But different. While the two companies compete quite directly in the enterprise services, storage systems, server, and software spaces, each has a skew: HP to the consumer with hardware and IBM to the enterprise with a broader and deeper technology-oriented services.

"And while HP has begun to effect a turnaround in its operations and its stock price, IBM has yet to achieve any great traction with either. The services business has been a drag, as competition has been heavy, while IBM's cost structure remained bloated. The hardware side has done well, but isn't experiencing across-the-board growth. Software has been the bright spot, with acquisitions, an environmental shift to open-source and other alternative systems driving revenue higher.

"Yet further gains remain. All that spells opportunity for greater long-term earnings expansion. Seduced by management's long-term goal of double-digit earnings growth, IBM's product line breadth and strong cash flow generation, and the stock's current 1.5% yield and easily digested valuation, we're buyers of the stock up to $83.19, and we might point out that IBM was always one of our founder Al Frank’s favorite stocks."

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