IBM has spent the last 10 years in a restructuring phase. As is reiterated in the recent annual report, the company is exiting commoditized businesses and further differentiating itself from competitors. Historically IBM had been a mainframe and hardware company, but as is evident by its financials it has evolved into somewhat of a software company. Software accounted for 43% of 2010 pre-tax income yet it produced only 22% of the company’s revenue.
From the 2010 10-K, figures in millions
Software companies like Microsoft have exceptionally high profit margins so the high margins in the software segment should come as no surprise. Microsoft’s 33% profit margin easily trounced IBM’s 14% in 2010, but IBM’s 64% return on equity bested Microsoft’s 40%. In the late '90s and early 2000s IBM had profit margins in the single digits, so perhaps it was the movement into software that has brought the net margin up.
Still, the slightly higher profit margins can’t explain the high returns to equity; instead the reason appears to be a gorging of debt. Over the past 10 years IBM has grown its debt to equity ratio some 40%. Microsoft just recently took on significant amounts of debt, but as a proportion to equity it has a much smaller figure than that of IBM. Taking on large sums of debt has the effect amplifying return to equity as net income is spread out over fewer shareholders. If Microsoft were to take on the kind of debt IBM has, its returns to equity would look even better than IBM’s.
The last factor in the return to equity metric, the sales turnover was fairly average. In 2010 IBM produced $99.8 billion in revenue on $113.4 billion of assets leaving the company relatively unchanged in asset efficiency over a 10-year span.
Like Microsof, IBM is very cash-flow rich and earns its interest charges many times over. But IBM’s large amount of leverage makes it unusual in the tech sector. Microsoft (MSFT), Apple (AAPL) and Oracle (ORCL) all have more equity than debt in their balance sheets. As much a cash cow as Coca-Cola (KO) is, it too holds a much lower debt to equity ratio than IBM. This makes Buffett’s investment somewhat vexing as he has generally shied away from companies with excessive amounts of debt. With the investment in IBM, Buffett certainly took a step in a new direction, in more ways than one.