I bought shares in IBM (NYSE:IBM) over a year ago, not long after Warren Buffett announced he had made a large investment in the shares himself. This is one of the few investments that I have been displeased with throughout, not because the share price hasn’t performed, but because the business itself has performed far below my expectations.
It wasn’t until recently, when I took a look at Oracle’s (NASDAQ:ORCL) performance, that I realised that my thesis on IBM was wrong and the investment wasn’t as undervalued as I thought originally. It is hard to admit you’re wrong, especially when IBM’s share price has been much higher recently than it is now, but it’s the right thing to do as an investor.
Both IBM and Oracle generate a large amount of free cash flow, which I always like to see in an investment. IBM’s free cash flow generation was 116% of net profit over the last 10 years; Oracles was 129% of net profit. They also earn impressive returns on investment which means they need little capital expenditure to grow the business. Take a look at the tear-sheets below for both businesses, and note particularly performance in the last year and the valuations.
IBM’s revenues are declining, and earnings declines have been partially offset with cost reductions but there is only so far this can go. Oracle on the other hand is increasing revenues and earnings, and although they are forecasting to have a fall in revenues next quarter, this is a due to a very high comparison Q2 last year (which saw 18% revenue growth in one segment).
Now it should be noted that Oracle spends more on acquisitions than IBM, but I have accounted for that in the DCF valuations given in the tear-sheets, the cash flow used is after money spent on acquisitions.
Finally, compare the current prices of both companies, IBM trades at a P/E ratio of 12.9, compared to Oracle at 12.7 (cash adjusted). But Oracle is growing and generates more free cash flow, compared to IBM which is seeing declining revenues and earnings. My DCF model shows IBM is fairly valued even if we assume it grew at 8% for the next few years, and is overvalued if it doesn’t grow yet continues to spend money on acquisitions. Conversely, Oracle appears undervalued, even if we take account of the $8bn tax bill it would face if it repatriated its offshore cash.
After looking at these I couldn’t defend holding IBM any longer, so I sold my whole position at a roughly break-even price (very disappointing over 2 years) and bought Oracle shares instead. I like to have a small part of the portfolio in a big defensive company that is a long term buy and old, and Oracle is simply the better choice.
Disclosure: Long ORCL, IBM no positionIf you found this post useful, please subscribe to receive new posts for free by email.
Or subscribe to the RSS feed.