2 Key Points to Consider Before You Give up on IBM

International Business Machines is the Dow's biggest dog this year. Year to date, the company has underperformed the Dow by nearly 27%, undoing approximately two years of gains.

However, I am personally still a bull, and I do not believe that I'm going down with a sinking ship. The market is taking a short-term view, ignoring long-term trends and placing no value on IBM's earnings growth or intelligent borrowing.

Dissecting earnings
One of the key points that many market participants took away from IBM's fiscal third-quarter earnings release was the company's revenue figure, which was down around 4% YoY.

However, the whole technology sector is suffering from similar revenue attrition as more competitors enter the market and drive down margins. IBM has been strategically shifting to higher-margin services for the past decade. Indeed, within the fiscal third-quarter results, IBM revealed that its year-over-year operating margin was 49%, up 1% during 2013, thanks to improving efficiencies within the company's global technology services, global business services, and global financing arms.

That said, revenue from the company's services division declined by 1%, but (and here's the key), pre-tax income from IBM's global technology services and global business services divisions increased 12% and 28%, respectively. In addition, both divisions increased pre-tax profit margins to 19.4% and 20%, respectively.

Rising income and widening margins are extremely important for IBM, as the company has always been affected by falling sales. The technology sector is becoming more competitive, but IBM's name and reputation has allowed it to achieve solid growth within high-margin service divisions. 

Attrition across the industry
IBM has very few comparable peers, but the best candidates for comparison are Hewlett-Packard and Cisco Systems , which have both seen similar trends in their hardware/software/service revenue income. Hewlett-Packard, for example, reported in its fiscal third quarter results that enterprise service revenue declined approximately 2.6% from the previous quarter. However, the division's earnings (before interest) and tax margin expanded to 3.3%, up from 2.6%. Furthermore, Hewlett-Packard reported expanding profit margins within its software division. In particular, software revenue fell 1% year over year, but the division's pre-tax profit margin expanded by 2% to 20% during the fiscal third quarter. 

Cisco also reported rising demand for its services. When the company reported its fiscal full-year 2013 results in August, it was revealed that overall revenue expanded 5.5% YoY, led by revenue from services, which grew 8.7%. This uptick in service revenue meant that 21.8% of Cisco's fiscal 2013 revenue was related to services, up from 21.1% during fiscal 2012.

What's more, Cisco also reported that, like IBM, sales growth in emerging margins had slowed. In particular, Cisco's revenue only expanded 3.6% within the Asia Pacific region, or APJC, during 2012, down from growth of 13.4% during fiscal 2012. Moreover, Cisco's APJC sales as a percentage of total sales fell to 16% during fiscal 2013, down from 16.3% during fiscal 2012.

Borrowing is good
Some market commentators have expressed concern about IBM's rising debt level and cash flow issues. However, the company is actually doing the right thing by borrowing while rates are low.

According to data from Morningstar, the vast majority of IBM's debt has an interest rate below 4%. Approximately $11 billion of IBM's debt offers a fixed coupon below 2%, so IBM is paying nothing to borrow, if inflation is factored in.

If that's not convincing, use another metric to calculate the interest costs of IBM's debt. According to MarketWatch.com, the company paid $98 million in interest during the fiscal third quarter, which was actually $52 million, or 35% less than it did during the same period last year. Based on the fact that the company has just over $36 billion in debt and pays interest of $92 million per quarter, or $368 million annually, the company is paying roughly 1% interest. This indicates that in real terms (i.e. including the effect of inflation), IBM is making money since it will ultimately have to pay back less than what was originally borrowed, (if inflation is assumed to be 2% per year, the company theoretically has to pay back 1% less every year).

IBM's debt-funded acquisitions and debt-funded buybacks are extremely beneficial to investors at this almost non-existent rate of interest. In addition, with a cash balance of $10 billion, the company has enough cash on hand to cover any debt falling due within 12 months.

Foolish summary
Investors should think very carefully before they write off IBM. The company is driving profitability within its service divisions and using cheap debt to buy back stock. What's more, IBM is acquiring a whole host of smaller peers to expand its global reach.

Taking a closer look at the Dow
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The article 2 Key Points to Consider Before You Give up on IBM originally appeared on Fool.com.

Fool contributor Rupert Hargreaves owns shares of International Business Machines. The Motley Fool recommends Cisco Systems. The Motley Fool owns shares of International Business Machines. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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