Lori Steele, General Manager of International Business Machines’ ( IBM ) stated in an interview,

As you look at our strategy, we continue to move our business and transform our business to the higher-value spaces. We’re trying to focus on software and analytics.

Above statement inferred — that the company’s business is shifting towards high margin business from low margin business. With the robust growth of cloud computing business, it is monetizing the opportunity by adopting an acquisition strategy. In this article, we have analyzed its recent divestiture and acquisition to find the impact on its earnings. Let’s discuss this in detail:

Acquisition of high margin business

IBM has acquired four companies to build its cloud business in the past three years. The company aims to upsurge the cloud related revenue from $3 billion currently to $7 billion by the end of 2015. To help it achieve this goal, it recently acquired Trusteer, an Israel-based Cyber Security Company. IBM is expected to pay out approximately $800 million in this acquisition. The security products of Trusteer will enhance IBM’s product portfolio, which develops solutions for mobile and application security. In addition to this, Trusteer has a strong client base, including seven of the top ten U.S. banks and nine of the top ten U.K. banks. This acquisition will give IBM access to Trusteer’s client base.

In addition, the U.S. federal government has been the major source of revenue for IBM’s security products over the past few years. Its enhanced product portfolio will attract more deals from the government since it always demands high security. We believe IBM’s enhanced portfolio will also attract more deals from the other organizations.

Its competitor Accenture ( ACN ) is following a similar strategy of gradually growing its business through acquisitions. Recently. it acquired ASM Research, an advanced information technology provider. ASM research has 30 years of experience in U.S. military and federal services and generated revenue of $27.9 billion in the last fiscal year. ASM’s strong expertise will give Accenture capabilities and opportunities to grow its business. Its earnings are expected to be $4.20 per share this year and $4.50 next year. Although this acquisition will impact the company’s earnings, vigorous competition from IBM will be the biggest risk to its earnings forecast.

Divestiture of low margin business in accordance with the company’s goal of transforming its business into high value propositions, last year, the company sold its low margin retail store system unit to Toshiba (OTCPK:TOSBF ), which brought $850 million in cash to the company. Further, in September 2013, IBM agreed to divest its customer-care outsourcing business to Synnex (NYSE:SNX ).

In 2012, this business division generated merely 1% of the company’s total revenue and has a low margin of around 20%, which is much lower than the 60 % margins of new business like cloud computing. The Synnex deal is expected to close at a value of $505 million, which will fetch $430 million in cash and $75 million in common stocks of Synnex. As a part of the transaction, Synnex will become a strategic partner with IBM and will provide customer-care outsourcing services to IBM globally.

Synnex’s core business is providing business process outsourcing services, or BPO, and this acquisition will expand its geographical reach. Inclusion of IBM’s customer care will make the company one of the top 10 players providing BPO services, enhancing its future earnings. Synnex’s earnings are expected to be $3.85 per share and are expected to increase to $4.23 in fiscal year 2014

In the second quarter of 2013, the company reported a gross margin of 48.7 %, whereas its X86 server business contributed a gross margin of merely 20 %. Continuing with the low margin business divesture, IBM is planning to sell its X86 server business. This server is the part of web architecture of the small as well as large companies, which manages the enterprise data, handles a simple file to a critical business application. Apart from its low margin, its sales fell 11% year over year. According to an analyst from Credit Suisse, the estimated value for this business is $3 billion, and the deal is anticipated to close in 2014. An analyst from Royal Bank of Canada estimates this divestiture to increase the operating margins in the range of 0.80 % to 1.50%.

We consider these divestitures as a good sign for IBM since it can continue focusing on software and cloud base customer relationship management. The continuous shift towards high margin business is expected to upsurge IBM’s earnings. This will help the company accomplish its goal of $20 EPS by 2015.

Incremental dividends from higher earnings

The company has a history of distributing incremental dividend every year as depicted in the chart above. With its various strategies, the company generates strong free cash flows, and it uses a portion of this to distribute cash to its shareholders. It had $11.73 billion of cash flows in 2012. It recently distributed dividends of $0.95 per share on August 7, 2013, an increase of 11% year over year. Also, the company plans to distribute dividends in the future with a forward dividend yield of 2.1% .

Additionally, the company’s strategy from low to high margin business will be a key growth driver for IBM’s earnings in the next two years. With the forward dividend yield and earnings growth rate, it will be interesting to analyze this stock with the Price/earnings to growth and the dividend yield, or PEGY, ratio. The company has a 12 months trailing EPS of $14.09 and forward 12 month EPS of $17.61. This implies a growth rate of 21.07% for the next four quarters. The company’s trailing P/E is 13.54, and with forward dividend yield of 2.1%, we get PEGY ratio of 0.58. A PEGY ratio of less than 1 is considered a desirable valuation multiple, which prompts a buy for this stock.

Bottom Line:

High margin businesses of the company will act as strong fundamentals of the company. Along with this the company has strong history of distributing earnings to its shareholders. On the valuation perspective, the stock is undervalued, indicating high growth earning potential. Therefore, it isn’t a questionable investment.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Fusion Research is a team of equity analysts. This article was written by Rohit Gupta, one of our research analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.

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