Can Watson Power IBM Stock to New Highs?

Watson the supercomputer is getting its own home in New York City. IBM (IBM) announced on Jan. 9 that it's creating a separate business unit for the computing system best known for defeating 74-time Jeopardy winner Ken Jennings in 2011.

Source: Wikipedia

While it's not enough to make me want to run out and buy IBM stock, the news sparked my interest in Big Blue. Watson has numerous applications, from business analytics to healthcare diagnoses that could affect IBM stock. The only question is: Will those applications materialize?

Should you have IBM on your buy list at the moment? I'll have a look.

Watson Powering Business Analytics

Watson is part of IBM’s business analytics software portfolio. The company hopes that Watson will generate $10 billion in annual revenue by 2023; it currently is responsible for less than $100 million of the $20 billion in revenue IBM expects to generate from business analytics and optimization software and services by 2015.

IBM is so convinced of Watson's potential for solving problems that it has committed more than $1 billion to create the new unit, including a $100 million venture-capital fund that will allow Big Blue to work with startup companies developing apps for Watson and sharing in the revenue.

It's very early in the process, but several industries including healthcare have benefited from the supercomputer's ability to analyze vast amounts of information to find answers to problems. As someone who writes about investments for a living, I can easily imagine investment-related businesses benefiting from Watson's efficient analysis of reams of data.

However, when all is said and done, Watson still represents a tiny fraction of overall revenue at IBM (assuming $10 billion in revenue by 2023). The future success or failure of IBM doesn't hinge on Watson.

Warren Buffett Likes Watson

Berkshire Hathaway (BRK.B) is the largest shareholder of IBM, with a little more than 6% of its stock. Buffett acquired the shares over a period of 27 months beginning in the first quarter of 2011, paying an average of $173 per share.

As of January 13 those shares have returned a minuscule 6.5% — hardly the stuff of legends. But look more closely and you'll see that IBMs stock price is trading well below its earnings line, which is based on a P/E ratio of 15, the multiple Peter Lynch used when comparing a stock's current price to the historical fair value of the market on the whole.

When the green line in the attached chart drops significantly below the blue line, the stock is considered undervalued. Only twice in the past 13 years has this happened for IBM and today is one of them.

Capital Allocation

You can argue all you want about the state of IBM’s business but it's harder to dispute its ability to successfully allocate capital.

In the 12 years between 2000 and 2012 IBM stock grew free cash flow by 8.7% on an annualized basis. During this period, operating margins expanded by 6.8% annually thanks to its evolution from hardware business into a software and service company.

Since 2000, IBM stock has returned $150 billion to shareholders, including reducing its share count by 35% through share repurchases. If IBM continues to buy back its stock at the same rate, Berkshire Hathaway will own 9.3% of IBM stock without buying another share.

In the three years between 2013-2015, IBM expects to make $20 billion in acquisitions and $15 billion in capital spending while still returning $70 billion to shareholders in the form of dividends and stock buybacks.

If the past 12 years is any indication, you can expect IBM stock to generate annual free cash flow of at least $18 billion or $54 billion over three years. With approximately $105 billion spoken for excluding debt repayment, it's going to need to pick up the pace if it wants to meet its goals without taking on further debt.

Regardless of what happens, it certainly generates enough free cash to support a higher debt load. Obviously, CEO Ginni Rometty is confident that it can meet its plans for cash over the next couple of years. I see no reason to doubt that.

IBM Stock Bottom Line

IBM stock has been a major disappointment the past couple of years, underperforming the S&P 500 by 10 and 33 percentage points respectively in 2012 and 2013. By comparison, Berkshire Hathaway has matched the index and should continue to do perform reasonably well.

So, should you have IBM on your buy list?

If it were me I'd be more inclined to buy Berkshire Hathaway's B shares to benefit from any resurgence in IBM stock. Having said that, I don't think you risk much owning IBM at current prices. With a reasonable dividend and significant share repurchases, shareholders could do a lot worse than owning IBM stock.

As of this writing, Will Ashworth did not own a position in any of the aforementioned securities.