As a careful reader, my attention was drawn to the following excerpt from IBM’s (NYSE:IBM) 4Q 2014 earnings conference call:
So over the longer term, when we look at the opportunities we will continue to develop, we see the ability to generate low-single digit revenue growth, and with a higher value mix, high-single digit operating earnings per share growth, with free cash flow realization in the 90’s. Of course we will spend more time on the rate and pace of achieving that trajectory at our investor meeting next month.
“Trajectory” is a favorite word for Schroeter, appearing some 17 times in the presentation. Now some wise-guy commenter is bound to observe, that if IBM continues on its current trajectory, it will crater. So I took the fun out of it, and mentioned it myself.
Here’s the point: If IBM resumes growth of revenue, the current forward P/E of 9.5 will increase. Using Graham’s old formula (P/E = 8.5 + 2G, where G is growth), a trajectory of 2.5% revenue growth would lead to a P/E of 13.5.
According to finviz, consensus EPS for next year is $16.81. Doing the math, $16.81 X 13.5 = $227, for an increase of 44% from a recent price in the $158 area.
Can You Get There From Here?
To date, IBM’s presentation of information on the strategic imperatives, cloud among the company, has been somewhat sketchy. It would give you a run rate, or a growth rate, but it would never lay it out in the type of detail that would be provided in a segment analysis.
On the conference call, Schroeter said that revenue for 2014, after adjusting for currency and divestitures, was down 2%. He also said that strategic imperatives ended the year at $25 billion, up 16%. Combining these two items, the rest of IBM shrank at 7.3%.
If you simply extend these two trends forward, in five years, IBM will be growing revenue 3.8% annually. That’s low-single digits, and consistent with Schroeter’s broad-brush trajectory as quoted. Assuming $5 billion per year in share buybacks, decreased share counts will add another 3% to EPS growth. It takes a while, but this eventually brings EPS growth up to high-single digits.
This exercise demonstrates that it is possible to extend IBM’s current trajectory to imply both revenue and EPS growth going forward. You can get there from here although it does take a while.
After factoring in the expected increase in P/E, the hypothetical share price trajectory looks like this:
The Devil Is In The Details
IBM will hold an Investor Briefing on Thursday, February 26. I’m planning to review the material presented with considerable care. Management at IBM has lost a lot of credibility over the Roadmap 2015 fiasco. I don’t think the company expected the reaction it got in October when shares tanked on the write-downs associated with the sale of the chip business.
To project the company’s future trajectory with any credibility, management is going to have to provide some concrete details, granular information on where growth is going to come from.
What Did Warren Do?
Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) will file a 13-F before the Investor Briefing. The pundits will be all over it, reading deep insights from any increase or decrease in the oracle’s position. I don’t have an opinion, other than the suspicion that an increase in Buffett’s position would spike the stock for a day or so.
Strategy And Tactics
I’m sitting on painful unrealized losses. I increased my exposure several times as share prices bumped along what hopefully was a bottom in the low $150s. The bulk of my position consists of deep, in-the-money LEAPS, which provide considerable leverage.
At a forward P/E of 9.5, further downside risk appears manageable, while the upside, as illustrated above, is enticing.
A hypothesis is different from a thesis. A thesis, you nail it to the door, defend it constantly, and retreat in shame and ignominy if it gets broken. A hypothesis, you reexamine it as new information becomes available, and modify or reject it based on the facts. My hypothesis is reflected in the chart above. I’m investing in ways that will be extremely profitable if it is confirmed.