WHY IBM SHARES WILL RISE TO $250!

IBM was recommended in this column last May at 106 as my favorite large cap technology stock of '98. Having risen as high as 198, IBM has definitely vindicated my faith in Big Blue in the last ten months. But is the IBM story over, now that it has blown away successive price targets at 160 and 180? Not at all. IBM is the most undervalued stock in the higher constellations of the Fortune 500 because Mr. Market still does not appreciate its superlative financial calculus and its calculated corporate strategy to exploit the most lucrative macro opportunities in the high tech world. In my opinion, IBM is headed to $250 a share in the next 12 months. Why? Seven reasons.

One, IBM is a classic case of continual corporate reengineering under its CEO Lou Gerstner, an ex-McKinsey management consultant whose obsession with shareholder value has led him to shift strategy from the boom-bust mainframe/PC product cycle that almost destroyed the firm in the 1980's to high growth, high margin based businesses that offer a much more stable, recurrent and predictable flow of revenues. In essence, Big Lou reinvented Big Blue since he took over as CEO in Armonk in 1994. Now software, IT consulting/services system integration, intellectual property (IP) licensing and sales account for 50% of IBM's gross/operating profits. Few people realize that IBM owns the world's second biggest software business in the world after Microsoft, a high margin perpetual money machine with similar financial parameters as the colossus of Redmond. Lotus Notes, for example, has a global installed base of 35 million users. Yet Bill Gates trades for 54 times forward earnings while Big Blue commands a mere 18 multiple. Mr. Market has given us a priceless gift for the last ten months in IBM's relative under valuation - and it is unwise to look at a gift horse in the mouth for too long on Wall Street because the best laid plans of mice and men go astray in the options market! Seriously, silly cliches aside, IBM's software business is a priceless crown jewel that is simply not given a rational weighting in its valuation multiple.

Two, IBM's high growth "annuity" businesses like software, IT services and maintenance all grow at 20% a year, have recurrent and predictable revenue streams, stable/lucrative gross margins (as high as 50%) and often unassailably high barriers to entry. Nor are these businesses a marginal contributor to IBM's revenue mix or profits. In 1998, Big Blues's annual global revenues were $82 billion, fifteen times the GNP of Bahrain. The "annuity" businesses contributed $30 billion in revenues and will account for 60% of '99 earnings. Their contribution to the revenue mix will only rise over time because the merger wave in the Fortune 1000 worldwide will boost IBM's' system integration business, the explosive growth of the Internet/E-Commerce will turbo-charge software and the global wave to outsourcing/ERP most benefits IBM's huge IT consulting businesses. In other words, the new IBM is no longer a hostage to the vagaries of the Silicon Valley hardware cycle, PC price wars or the Fortune 500's capital spending budgets.

This is the reason why it makes no sense at all to me that Mr. Market values IBM at only 22 times current earnings. Its secular growth rate, global competitive advantage, technological edge, product mix, gross margins and predictability of profits growth is far more attractive than Coca-Cola. But Coke still trades at 40 times on Wall Street. Another classic Mr. Market blunder - and another classic money making opportunity for us!

Three, knowledge has replaced capital, labour and commodity inputs as the most: valuable factor in the digital, networked global economy of the next millenium in businesses as diverse as banking, pharmaceuticals, services or computers. IBM's entire corporate strategy revolves around products with a high "intellectual property" content. This was the real message behind its recent $16 billion OEM deal with Dell to provide technology components in data storage, microelectronics, networking equipment and HDD displays. IBM earned $1 billion last year from patents and royalty fees earned from technology licensing. This "pure knowledge" business has an incredible 97% gross margin, is the R and D platform for IBM's $7 billion, 40% CAGR technology products sales division and is a mini-Silicon Valley out in Big Blue's Armonk seat. IBM was awarded no less than 2700 software/tech patents since 1994, for example. The next generation of high performance servers to link the next milleniums global Internet data and telecommunications networks will require multi-billion dollar investments in microprocessor technology that only IBM and Intel can undertake. For instance, the new IBM giga hertz microprocessors have 35 million transistors and based on proprietary 0.18 micron copper technology. Has Mr. Market factored in IBM's revolutionary microprocessor technology's awesome potential to redefine the computer industry in the next ten years? No way.

Four, IBM is becoming a "defensive" tech stock because only one-fourth of its pre-tax profits comes from volatile product cycle driven hardware sales, once its core business in the early 1990's. PC's are only one-eight of its global revenues. Yet its PC notebooks, OEM disk drive and mainframe businesses are all doing well, with new product introductions in fall '99, new value added technologies, new service/licensing deals with strategic partners like Dell. In short, while boom-bust cycles are an existential reality for any hardware manufacturer, IBM has reengineered its corporate strategy and product mix such that even a slowdown in PC growth or capital spending budgets will not hurt its bottom line to any great extent. This makes it a far lower risk stock than say, Dell. Yet Dell still trades at 70 times earnings. Alas, the virtues of a telegenic CEO!

Five, IBM is one of ht Big Board's most prominent free cash flow machines. In 1998, Big Blue generated no less than $6 billion in excess capital. It is no coincidence that IBM operates one of the world's biggest share buyback programs. Almost one-fifth of the float has been retired since Gerstner became CEO IBM will reduce 8% of its outstanding shares each in '99 and next year. This alone is a compelling argument for higher share prices in the months ahead.

Six, IBM in the late 1990's is a growth engine with a CEO and management team who have reinvented its business model, strategy, culture and product mix to deliver stable 15-18% profit growth over the next five years. Gerstner sold IBM's non-strategic divisions, slashed costs, got rid of the bureaucratic old guard, invested billions in new growth businesses like software/services and has set his sights on becoming a global leader in the post-PC world of Internet appliances. In fact, this management team has no sacred cows. Since IBM does not have the economies of scale (a la Compaq) or logistical excellence (a la Dell) to be the world leader in PC's, a sale/divestiture of the PC business to boost shareholder value is not beyond the realms of the possible. If so, a sale of the PC business could add $15-20 per share in value immediately to IBM. Can it happen? Everything Gerstner has done since 1994 convinces me that this is the logical conclusion of his crusade reinvent IBM.

Seven, IBM will earn $7.5 this year and as much as $9 a share next year. Book value is $23 a share and its price/sales is 2X. Dell trades at a 70 forward P/E, 6X price to sales and a 57 price/book even though its financial risk is far higher, its technological edge lower and exposure to commodity products greater than IBM. This makes no sense to me. It is another irrational blunder by Mr. Market. My conclusion? IBM should and will trade up to 26 times next year's Wall Street earnings consensus. This is not at all a fantasy valuation for one of the world's biggest, richest and safest technology growth franchises. If I am right, then "fair value" on IBM is $250 a share in the next twelve months. IBM is 178 now. So the Jan 2000 IBM calls 180 strike can well rise from 28 now to 60 - 70 by New Years Eve.

MATEIN KHALID
PORTFOLIO MANAGER
GULF AL BARAKA INVESTMENT LLC

The opinions expressed by the writer are his own and not endorsed by Press Release Network.

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