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Buy into IBM's metamorphosis
The computing giant is buying yet another software maker as it transforms itself into a company built around services and software. Wall Street hasn't yet bought into this sea change, so IBM's stock is cheap.
By Robert Walberg
Database giant Oracle has taken plenty of flak from the financial community for its buying spree over the past couple of years. But Wall Street seems to be giving IBM (IBM, news, msgs) a free pass on its proposed $1.1 billion acquisition of Ascential Software (ASCL, news, msgs).
True, IBM isn't in the midst of integrating another deal at the same time, as is the case with Oracle. But when Big Blue completes the Ascential deal, it will have gobbled up more than 20 software companies in the past four years.
I'd call that a buying spree. So why doesn't IBM face the same integration concerns that are weighing on Oracle (ORCL, news, msgs)? A number of reasons, including:- IBM's deals generally have been small. Even the $1.1 billion price tag for Ascential isn't that big when you consider that IBM generated more than $10 billion in free cash flow over the past 12 months. And did I mention that its software business alone delivered revenue last year of more than $15 billion? Or that total revenue for IBM over the past year totaled $96.3 billion?
- IBM knows how to integrate acquisitions. IBM has an impressive track record of successfully integrating these smaller software/services companies into its corporate structure. This is likely to be the case with Ascential. Ascential represents the other half of Informix that IBM didn't buy in 2001 when it paid about $1 billion for that company's database business. And Big Blue and Ascential have partnered on numerous projects in the past and have more than 500 joint customers.
Jump in
Basically, there appears to be little chance of a culture war when IBM integrates Ascential into its fast-growing information-integration unit. So investors might consider taking this opportunity to buy into IBM's strategy.
Aside from deserving kudos for its ability to scout out companies that fit within its corporate structure, IBM deserves credit for its overall vision and ability to switch gears with what seems to be little effort, not an easy task -- especially for a company its size. The Ascential deal is yet another reminder of the company's major sea change. Here we are discussing IBM's 21st software acquisition within the past four years, at the very same time that the company is working to complete the sale of its personal-computer business to China's Lenovo Group.
IBM understood years ago that profit margins would continue to decline in the increasingly competitive box-building business, and that software and services were where the money would be. So it focused its growth strategy around these areas. The units now account for more than half the company's annual revenue.
By contrast, under the failed leadership of Carly Fiorina, Hewlett-Packard (HPQ, news, msgs) paid big bucks (some $25 billion) to acquire Compaq Computer and its commoditized PC business. The move crippled H-P's stock and eventually cost Fiorina her job..
Better positioned
Though IBM's transition into a software/service giant from computer manufacturer has not been without bumps, it has left the company well-positioned for better-than-industry growth. The Ascential deal should only help. The company posted revenue of $271 million in 2004, up 46% over 2003.
Ascential develops data-integration software that compiles data from numerous sources such as catalogs, the Internet, storefronts, etc. and deposits that data in a single resource so customers can more quickly and efficiently analyze multisystem operations.
The ability to integrate information and applications is just where the good folks at IBM see its customers spending a growing percentage of their information-technology budgets. Ascential will help Big Blue address this gap in its software business, especially as it relates to the fast-growing retail and health-care industries.
Just how big is the data-integration business? According to the research firm IDC, the worldwide data-integration market will grow to nearly $14 billion a year by 2008, from a mere $9 billion in 2003. By acquiring Ascential, which added almost 80 customers last quarter alone, IBM thrusts itself into a leadership position in this dynamic market.
IBM has a keen eye; Wall Street has a memory
With Oracle, IBM, SAP (SAP, news, msgs) and Microsoft (MSFT, news, msgs) positioning themselves for leadership positions in the still-fragmented software industry, look for the recent wave of consolidation to continue. IBM has shown that it has a keen eye for smaller companies with good growth prospects, and the Ascential acquisition proves that Big Blue hasn't lost its touch. (Microsoft publishes MSN Money.)
Still, the cumulative effect of IBM's acquisition spree, the prospect of additional near-term deals and the transition out of the PC business haven't been lost on investors. IBM's stock has spent the majority of the past two years confined to a relatively tight 10-point trading range, roughly $80 to $100.
Big Blue also trades at only 15.9 times and 14.5 times estimated 2005 and 2006 earnings of $5.62 and $6.16, respectively. These multiples not only put the stock at the low end of its five-year valuation range, but they also leave IBM trading at a considerable discount to its peers and the market.
Ready to climb
Considering IBM's strong balance sheet, quality management, cash-generating capacities, leadership position in the industry and past success in integrating smaller software/service companies, there's no reason to think that the company will continue to toil at these discounted levels for very long.
Instead, IBM's focus on higher-margin, fast-growing segments of the technology industry suggest that the stock will experience material multiple expansion over the intermediate to long term. Assuming the company merely hits its targets, a multiple of 18 times to 20 times earnings should be attainable. That targets a move to the $110 to $123 area over the next 12 to 18 months, or 23% to 37% above the recent price of $89.51.
With that kind of return sitting on the table, maybe investors should take a cue from IBM and start to do some buying in the software industry. But instead of thinking small, they might want to think big, as in Big Blue itself.
At the time of publication, Robert Walberg neither owned nor controlled shares in any equities mentioned in this column.
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