When Northlake began in 2004, our strategy was to combine investments in broad market indices, thematic market indices, and individual stocks with adjustments for individual clients based upon their unique goals objectives and tolerance for risk.  This strategy remains in place today with a slight modification to the approach for individual stocks.  Back at the start, the individual stock portfolio was almost exclusively in media stocks.  Steve has spent a career analyzing media companies and with index funds making up the bulk of client equity portfolios, the concept of going narrow and deep in industries where Northlake had an edge was attractive.  Over time media and entertainment has been disrupted by internet delivered services, most notably Netflix.  This led Northlake to diversify individual stock portfolios into adjacent areas of consumer’s time.  Alphabet and Facebook being new media companies were an obvious example. Activison Blizzard, a leading video game company, is an entertainment company but unaffected by the changes to the world of TV and movies.  MGM Resorts, the largest domestic casino entertainment company is also a recipient of consumer time and money spent on entertainment.

More recently, cord cutting and sharp rating declines for traditional TV networks have led us to search for more ways to diversify Northlake’s individual stock portfolio.  This brings us to International Business Machines (IBM).  Northlake has added IBM to the individual stock portfolio.  Purchases were made a little over $138.  We see initial upside to $162 over the next six to twelve months, upside of 17% plus an annual dividend yield of 4% for total return over 20%.  Should our investment thesis take shape as we hope, upside could be considerably higher.

We have been monitoring IBM for some time, intrigued as the company tried to shift toward growth businesses like cloud computing and artificial intelligence.  The company has had modest success but not enough to overcome a steady downtrend in its traditional hardware business.  IBM was forced to discount services to keep its own large enterprise customers and to win business against strong competitors like Amazon and Microsoft.  This led to consistent shortfalls in gross margin and profitability.

IBM’s most recent earnings report revealed that the long, slow move toward the payoff may have been reached.  Revenues came in a little better than expected and gross margins surprised to the upside.  We believe this is the start of improved financial performance that will only be enhanced by IBM’s recent acquisition of Red Hat.  Red Hat supports the company’s strategy to pivot toward growth end markets in cloud, artificial intelligence, and security.

We see a parallel between IBM and Cisco Systems.  Cisco also went thru a period of stalled growth as its end markets underwent secular change.  It took a while but the company shifted its focus, both internally and through acquisitions, until revenue and profit growth finally inflected higher.  Once it reached the tipping point, Cisco’s P-E multiple recovered from 10-12 times earnings to 15.  The shares have gained about 70% since mid-2017.  IBM faces a tougher task than Cisco did but the shares today trade at just 10 times 2020 estimate earnings.  We think a couple more quarters where IBM shows its strategy is working can lead to multiple expansion to 12 times or a price of $162.  While we wait we earn a safe dividend yield of over 4%, increasingly valuable with interest rates again near all-time lows.  Risks include competition, foreign exchange, and management missteps.  We are willing to take those risks after the company’s long stretch of poor performance given the green shoots we see in recent results.

IBM is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts.  Steve is sole proprietor of Northlake, a registered investment advisor.  Northlake’s regulatory filings can be found at www.sec.gov.