(By Mani) International Business Machines Corp. (NYSE:IBM) is a name that doesn't need any formal introduction as it has been a company that has rewarded investors with consistent earnings growth, strong cash flow, an eye for strategic acquisitions, and returning excess cash to shareholders via dividend and repurchases.
Armonk, New York-based IBM, which has shifted revenue from hardware to services to software, is the only computer company to succeed in nonconsecutive tech waves thanks to its excellent strategy and renewed thought leadership.
The combination of the right strategy and strong execution caused the stock to rise in the last decade by 178 percent compared to the S&P 500's 44 percent.
IBM could beat its new earnings goal of $20 in 2015 as margins expand thanks to software and productivity savings while share count drops. Earlier, it topped its 2010 goal with earnings of $11.67 a share.
Following 2011's 15 percent earnings growth to $13.44 in 2011, IBM needs just 10 percent compound annual profit gains to achieve its $20 EPS target in 2015.
"We expect IBM to beat this goal by about $1 per share based on the three sources of profit growth: revenue, operating leverage, and share repurchases," UBS analyst Steven Milunovich said in a client note.
In fact, billionaire investor Warren Buffett's 5.6 percent ownership stake suggests he sees reasonable growth and strong cash flows ahead for Big Blue.
However, revenue growth could continue to disappoint as services and Unix sales come under pressure. Revenue growth is expected to deliver an incremental $3.05 in EPS through 2015. The expected revenue growth of 4 percent per year is most likely to fall short as it did in the 2007-2010 roadmap due to the recession.
"Macroeconomic issues could again be a problem, in our view, as money printing around the world has only kicked the debt can down the road. We estimate revenue to rise at a 2-3% pace to hit about $118bn in 2015," Milunovich noted.
However, the operating leverage should offset some of the revenue shortfalls. The company argues that a 40 percent yield on productivity savings contributes $1.20 per share to 2015 EPS.
Revenue mix shifts generally help margins as higher-growth offerings and geographies tend to be more profitable. The most important shift has been and will be the gross margin boost from a higher software contribution
Meanwhile, IBM is always known for its expertise in acquisitions. The company seems to have stuck to its discipline, preferring software deals in the range of $200 million to $1.5 billion that can leverage the company's global distribution.
Some 15 of the 17 completed deals done in 2010 contributed positive non-GAAP profit growth in the first year. IBM focuses on gaining quick traction in the first two years, in the belief that early success sets the tone for the future.
Moreover, acquisitions are expected to provide 2 percent of the company's anticipated 4 percent total annual revenue growth through 2015.
For the second quarter ended June 30, 2012, Big Blue reported net income of $3.88 billion or $3.34 per share, higher than $3.66 billion or $3.00 per share for the year-ago quarter. Excluding items, it earned $3.51 per share, topping consensus view of $3.42 per share. Quarterly revenue fell 3 percent to $25.78 billion that came in short of analyst's estimate of $26.28 billion.
"The next couple of quarters could be soft given financial/public industry exposure and currency hits, followed by improvement when new mainframes ship," Milunovich said.
However, IBM returned $4.0 billion to shareholders during the second quarter through $1.0 billion in dividends and $3.0 billion of share repurchases and ended the quarter with $11.2 billion of cash on hand.
In April, IBM hiked quarterly dividend by 13 percent and also authorized $7 billion in additional funds for use in the technology giant's stock repurchase program.
IBM's payout ratio of 22 percent has room to go higher as it is expected to return at least $70 billion to shareholders. After 2011's 75 cents per share earnings contribution from buybacks, the remaining $35 billion of share repurchases needs to support an additional $2.05, which looks very doable.
Investors should focus on earnings and shareholder returns from IBM as there is a risk to Street revenue projections in the next few quarters but less to earnings. Weakness is Europe, which accounts for one-third of revenue and exposure to the financial and public verticals that represent almost half of revenue make downside surprises quite possible.
"IBM has a habit of protecting margins, which suggests less downside earnings than topline risk," Milunovich said.