Stock Faceoff: IBM versus Computer Sciences Corp

You might think it's unfair to pit IT consulting firm, Computer Sciences Corp (CSC) against hardware, software, and consulting behemoth, International Business Machines (IBM). But both are highly dependent on growth in the IT consulting industry. And Tuesday, CSC suffered a nasty spill on anticipation that its earnings would come in below expectations. Does that price plunge make CSC a bargain or are you better off with Big Blue in your portfolio?

CSC ended Tuesday down 12.9% after issuing a warning about its report for the most recent quarter. According to The Motley Fool, CSC is going to disappoint investors when it announces results for its fiscal fourth quarter ending March 2011. In February, CSC predicted revenue of $16.2 billion and EPS of $5.20 for the 2011 fiscal year that ended in March. However, Tuesday it announced that its revenues would come in $100 million short and its EPS would be 45 cents, or 9% below the level it predicted in February when it announces its results on May 25.

And it now looks like CSC's fourth quarter results will come in 44 cents, or 28% below analysts' estimate. CSC also said it expects the U.K.'s National Health Service to slash the size of a large contract and that federal procurement delays are going to reduce its backlog. This makes me think that CSC is too dependent on the government sector that is likely to be shrinking as countries try to cut their budget deficits.

Meanwhile, IBM is going gangbusters. As I wrote on April 21, IBM beat expectations and raised its guidance after reporting first quarter earnings on the 19th. Its operating earnings rose 21% to $2.41 a share — beating estimates of $2.30 a share – on revenues that climbed 5% to $24.6 billion. Not only that, but IBM boosted its EPS estimate for 2011 from “at least $13″ to “at least $13.15.” The results were strong due to new hardware, up 40%, and a rise in analytics software, up 20%, about which I wrote, that could account for $16 billion in 2015 sales.

A deeper look at the IBM results reveals that while services are a big portion of IBM's revenues, they are growing more slowly and have weaker profit margins than IBM's star business -- software. IBM's services business, that accounts for 60% of its top line, reached about $15 billion in revenue, up 6% from 2010 and earning a pretax margin of 12.5%. IBM's smaller software business grew faster with much higher margins -- generating sales of $6.1 billion in revenue, up 6.3% from 2010 and earning a pretax margin of 28.3%.

But if you're looking to make an investment decision now, this analysis should only be part of the story. You might also consider using the price-to-earnings-to-growth (PEG) ratio that compares a stock’s market valuation to its forecasted earnings growth. By that measure, if a stock trades at a PEG of 1.0 or lower, it is reasonably priced. Higher than that, and it looks overvalued.

Here are the results of this analysis for CSC and IBM:

• CSC — 1.60. It trades at a P/E of 8 on earnings forecast to grow 5% to $5.47 by 2012
• IBM – 1.46. It trades at a P/E of 14.6 on earnings expected to grow 10% to $14.57 in 2012

At these PEG levels, buying IBM looks like a better play -- not so much because the stock is cheap but because it is likely to keep executing so well each quarter and thus sustaining the 33% growth rate in its stock price over the last year (as CSC's stock has tumbled 15%).