A trusted brand and an unrivaled product and services portfolio hold IBM in good stead.

IBM's technological leadership and sticky products and services will enable the company to deliver steady recurring revenue for a long time.
IBM's offerings cover a wide swath of the technology industry, including hardware, software and services. The company faces different competitors in each segment, but maintains a leadership position in most areas through a combination of investments in research, worldwide distribution, and a respected brand.
IBM's hardware product portfolio is composed mainly of proprietary mainframes, industry-standard x86 servers, storage systems, and proprietary microprocessors. Despite decades-old predictions of the death of the mainframe, these systems continue to generate profitable recurring cash flows as some customers are reluctant to port legacy applications to newer systems. Additionally, mainframes perform very well for certain high-end applications, though this market is a small fraction of the overall server market. The firm also has substantial market share in the x86 server market, but the economics of this segment are less attractive than proprietary servers because of greater competition from rivals such as Hewlett-Packard HPQ and Dell DELL.
IBM's software business is mainly focused on operating systems, infrastructure management for data centers, and application middleware for software development and deployment. IBM's z/OS mainframe operating system is provided to customers on a rental basis, thereby generating recurring rental revenue for the life of the mainframe. Infrastructure-management tools and application middleware tend to be very sticky and generate recurring maintenance revenue from annual support contracts. IBM's ownership of the mainframe platform and wide distribution through its services organization enable the firm to effectively compete with HP, CA CA, and BMC BMC in the infrastructure-management market, and with Oracle ORCL and Microsoft MSFT in the application middleware market.
IBM's services organization offers a wide variety of services: managing the day-to-day operations of large data centers, business process outsourcing, and developing custom systems to address customer needs. Outsourcing contracts are sticky and generate annual recurring revenue over the contract duration, typically five to seven years. Although the company competes with several large service providers such as HP, Accenture ACN, Computer Sciences CSC, and Infosys INFY, the addressable market is very large, and IBM's trusted brand and strong product portfolio give it an edge in winning new services business.
Although each of the above businesses is an industry leader in its own right, the combination of these products and services provides IBM with an unrivaled solution creation and delivery ability that is the key to its wide economic moat.
However, new challenges are on the horizon. The advent of cloud computing could throttle demand for IBM's high-end hardware products, slowing down the company's virtuous hardware-plus-software-plus-services cycle. Oracle's acquisition of Sun is an attempt to create a competing integrated hardware and software stack and could reduce demand for IBM's system-integration services. Despite these developments, IBM's product development and distribution scale and entrenched customer relationships position the company well to respond to competitive threats and maintain its leadership position for a long time.

Valuation
Our fair value estimate for IBM is $182 per share, which implies forward fiscal 2012 price/earnings of 12.8 times, Enterprise Value/EBITDA of 9.3 times and a free cash flow yield of 8%. We are maintaining our revenue growth forecast in the low-  to mid-single digits during the next five years. We expect operating margins to remain flat as benefits from strength in high-margin software sales will likely be offset by a rebound in personnel costs in the global services businesses. If management is able to increase operating margins in the global services business while software sales outpace lower-margin businesses, our fair value estimate would rise to about $214 per share. On the other hand, if global services operating margins decline to prerecession levels, our fair value estimate would retreat to about $135 per share.

Risk
IBM's high-end computing hardware business (namely mainframes and power systems) faces ever-increasing competitive pressure from commodity x86-based servers. Cloud computing makes vast computing capacity available on-demand and could lower revenue and profit opportunities for IBM's high-end hardware business. IBM's custom, best-of-breed approach to meeting customers' needs is being challenged by Oracle's potentially cheaper integrated solutions that aim to meet 80% of customers' requirements without expensive customization. The firm's limited application software portfolio places it at a competitive disadvantage, relative to Oracle, in delivering integrated business solutions.

Management & Stewardship
Virginia M. Rometty took over as CEO of IBM on Jan. 1. Rometty was formerly senior vice president and group executive for sales, marketing, and strategy and has been with the company since 1981. Former CEO Sam Palmisano is the chairman of the board. We are glad the firm used Palmisano's retirement as an opportunity to separate the CEO and chairman roles. Palmisano's total 2010 compensation was about $31.7 million, which was reasonable for his stewardship of the firm, in our opinion. Executive compensation is heavily weighted toward short- and long-term incentives that are well-aligned with creating shareholder value. Board members receive the majority of their compensation in the form of stock, which is good for aligning their interests with those of outside shareholders. Our overall positive view of the firm's management is slightly colored by the use of retention packages awarded to some senior executives.

Overview

Financial Health: 
IBM has nearly $17 billion in cash and equivalents, and about $31 billion in debt. The firm generates adequate cash from operations to cover its debt obligations while continuing to invest in growth opportunities.

Profile: 
IBM is one of the largest information technology companies with an array of offerings, including system hardware, infrastructure software, outsourcing, and systems integration services. The firm has operations in more than 170 countries and generates about 65% of revenue from abroad.