10-year

10-Year Anniversary Promotion (20% off)

Join GuruFocus Premium Membership Now for Only $279/Year

Once a decade discount

Save up to $500 on Global Membership.

Don't Miss It !

Free 7-day Trial
All Articles and Columns »

The Simple Case for IBM

May 13, 2014 | About:
Grahamites

Grahamites

156 followers

Recently there has been a lot of criticism and doubts with regards to Berkshire Hathaway (BRK.A)(BRK.B)'s investment in IBM. Some people even claim that the Oracle of Omaha has lost his touch and stepped out of his circle of competence when he poured billions of dollars into IBM (IBM).

I bet if you ask those critics how they judge the success or failure of Berkshire's IBM investment, they would say it's a bad investment because IBM's share price has not moved much since Buffett's purchase.

This is the perfect illustration of the concept of time arbitrage. When Buffett bought IBM, he didn't have a sell price in five or seven years. He even welcomed potential price drops so he could pick up more shares. IBM is likely to be a permanent holdings for Berkshire, just like American Express and Coca-Cola. But why is that?

In an interview with Becky Quick, Buffett's long-term partner, Charlie Munger (Trades, Portfolio), said the following about the IBM investment: "I was perfectly OK with it. It's a very Buffett-style play. It's simple. They announced what they were going to do and why they thought it was going to work. You could see how entrenched IBM was in many places, including the Burlington railroad."

Charlie Munger (Trades, Portfolio) summed up the thesis in a typical Munger way. But he didn't tell the whole picture.

I won't go into details of IBM's business and all the financial information. Interested readers can do their own work. My purpose of writing this article is to lay out a few very simple points about IBM to illustrate why I believe IBM will do very well for Berkshire in the long run. Let's take a look at IBM's ValueLine Report:

First of all, as we all know, IBM's business model has changed. IBM gradually transitioned into a software and enterprise-service company from a hardware-based business. What has not been widely recognized is the impact on profit margin. Prior to the transition, IBM's net profit margin was hovering around 10%. This is not bad, considering American businesses earns about 6% to 10% on average.

When Buffett's started to purchase IBM, its profit margin has already show signs of improving. Now, a few years later, IBM's profit margin has expanded to almost 18%. This is a remarkable achievement. What's more remarkable is that IBM has built a sustainable and formidable moat at the same time. Now IBM has large and well-established hardware, software and services businesses, each of which has high switching costs and recurring revenue streams. With billions of dollars spend on capex and R&D every year, I can see IBM's moat being intact in 10 to 15 years.

Second, as Chuck Akre (Trades, Portfolio) pointed out in his presentation, in the long run, return in common stocks will correlate to the return on equity. I will point out that although this is in general true, there is one catch, which I'll explain later. IBM's ROE is admirable. If you look at the latest Value Line report, you will see IBM's return on shareholder equity during the past five years has been over 50% and is projected to be over 30% in the next couple of years. This is mostly achieved by high net profit margin and a little bit equity leverage.

Third, IBM is a cannibal. Share counts have been shrinking every year in the past 15 years. Through years of share buybacks, IBM's common shares outstanding have decreased from 1.85 billion in 1998 to merely above 1 billion shares today. This is extraordinary for a business as large as IBM. And it will continue to shrink the share count so if you are a shareholder now, you are almost guaranteed to own a larger portion of a wonderful business as time goes by. Buffett has done the math for us. Interested readers can go back to Berkshire's 2009 annual report.

I have laid out my simple case for IBM. We have a great cannibal business with very high margins, very high return on equity and a tailwind working in its favor. The question is, why is the stock price almost stagnant during the past couple of years? Well, nobody knows that for sure. But in my view, it is the lackluster sales growth that hinders IBM's multiple expansion. This is the catch I mentioned earlier. A business with high margin and high ROE needs to have growth in order to unlock the full value of the franchise. IBM's sales have actually declined during the past four years or so. And investors have been extrapolating the future growth based on recent performance. I believe this is the main reason why IBM's stock price has been stagnant.

I am not going to forecast the future. But I do see IBM will likely to continue to enjoy the secular trend toward distributed, open-standards computing. Furthermore, IBM's hardware, software and service business each is the leader in the area, the combination of these businesses provides IBM with economies of scale in product development and distribution of services. IBM's established franchise as the indisputable leader in computing gives it a significant competitive advantage in acquiring new services business.

Considering all the above factors, I think there is a good chance that IBM in 10 years will generate much higher revenues. When growth kicks in, with a high margin and high ROE, IBM will likely to enjoy the double joy of profit expansion and multiple expansion. Again, I don't know when this will happen but the odds are good.

Disclosure: No position in IBM.


Rating: 4.2/5 (17 votes)

Voters:

Comments

leclerc
Leclerc premium member - 7 months ago

I think the author meant to say, "carnivore" not "carnival?"

rsn
Rsn - 7 months ago

I think he meant cannibal

SeaBud
SeaBud premium member - 7 months ago

Funny that the article concludes "No position in IBM". I do have a position in IBM, and I am an engineer so this might be presumed to be in my circle of competence. It is not. Where, when and how cloud services will grow is anybody's guess, and this investment is not "go to sleep for 20 years and then check back". Margins will likely narrow.

However, three things keep me invested:

- IBM's balance sheet is a rock. No fall will be quick and I get a nice dividend to watch this unfold (and I will pull out if the plan for growing, or at least stable, revenue plan is not rationale).

- IBM does have a moat. Nobody gets fired for hiring IBM. Large companies make decisions that protect the job of the decision maker. Smaller companies chase cheaper prices.

- Security requirements are real. Look at the cost of the Target data breach. While cloud services are becoming cheaper and more competitive, there is a strong place for a trusted brand like IBM.

I have been in the technology business for decades and I have watched this movie with IBM before. They have always transitioned and come out ok. Have they been lucky, well managed or something else? I don't know, but it is too attractively priced right now to jump ship.

Grahamites
Grahamites premium member - 7 months ago

Leclerc and Rsn: Thanks for spotting my typo. Yes I meant cannibal.

Grahamites
Grahamites premium member - 7 months ago

SeaBud: Thanks for the comment. I like IBM's business and I like the simple case for it. As a Berkshire shareholder, I like the fact that for company as large as Berkshire, Buffett and Munger really did a remarkable job identifying IBM as a long term core holding. But for me, since I'm not restricted by the size of capital, I just think there are common stocks of much smaller businesses that offer a higher potential return on investment than IBM.

That being said, I think you'll do very well with a position in IBM. Like you said, nobody gets fired for hiring IBM. The business will most likely continue to do very well.

chneeley
Chneeley premium member - 7 months ago

Did not see the word "cloud" in this analysis and what the "cloud" is doing to impact IBM business model. This is the big concern for me.

Grahamites
Grahamites premium member - 7 months ago

Chneeley: I understand you have concern for cloud. I intentionally leave it out because I want to focus on the 3 simplistic things. I can devote another whole article on the impact of cloud on IBM but the short answer is, with IBM's track record of detecting what's important in the enterprise world and investing heavily into the growth market, they are likely to adapt well to whatever new concept out there, be it cloud or SaaS, you name it. If you want to see what IBM has done in terms of cloud, please read IBM's 2013's annual report, it has a whole section on cloud and how IBM's invested billions of dollars on cloud. Thanks for commenting.

Hpeterscheck
Hpeterscheck premium member - 5 months ago

I agree with this and have bought IBM twice in the past 2 years. To me there are two reasons to buy a company: it is the low cost winner or it is the brand leader with price control. IBM is mostly the second but not so much in a consumer way. I like that they are exiting the commodity consumer hardware business... Let Lenovo have it instead of trying to compete with 1000 Chinese computer manufacturers on price. Also for things like cloud hosting/computing. Let amazon and google battle it out as their margins in this area drop and costs go down.

I think where IBM wins is in areas of innovation (stuff like Watson) which then leads to patents and partnering with large companies and governments and providing high quality (read expensive and high margin) services and support because you KNOW IBM will probably be around in 20 years when the cheaper alternatives might be gone. That's not a bad moat. Is it a Coca Cola moat? No. But at its current value it's a more affordable castle with quite a few sharks and mines in its surrounding moat :).

It's that reliability and margin in service that makes me think IBM as a company is a "close the market for 20 years and I'd still buy" kind of stock. I have no idea if I'll use facebook or twitter in 20 years... Or if I'll have an apple or an android, or if I'll buy from amazon or ebay. I am pretty sure I'll be using some kind of computing device and I'm pretty sure that IBM will be involved in those devices and services in some way.

I think the catalyst for the fair to low valuation is exactly what you say... Where's the growth? It's easy to do a linear extrapolation and conclude IBM will be dead in 5 years. Of course that same extrapolation makes some social media companies the largest companies in the world in 5 years. I'll leave it the reader to decide the value of this extrapolation. Personally I find that when a company can increase margins during a time of business contraction it shows great discipline on behalf of management. This makes me want to buy IBM even more. Keep the price low and let me accumulate more over then next year or two or three. In fact another 20% dip in price would make me quite happy.

im in no hurry.

hermann

batbeer2
Batbeer2 premium member - 5 months ago

@Chneeley

You say: >> Did not see the word "cloud" in this analysis and what the "cloud" is doing to impact IBM business model. This is the big concern for me.

The cloud is not a problem for IBM.

IBM invented the coud. Without virtual machines, there would be no cloud.

In any case, Apple is now moving siri to the cloud. They need IBM to do it. The new, more intelligent siri is based on IBMs Watson platform. http://www.apple.com/pr/library/2014/07/15Apple-and-IBM-Forge-Global-Partnership-to-Transform-Enterprise-Mobility.html

Siri can tell you when your plane is leaving but Watson can tell a farmer the best day to plant his corn. There has been some discussion about how this partership will affect Apple's earnings but hardly anyone is taking note of the fact that Apple needs IBM to add some intelligence to its cloud.

What's more, with Watson, siri will put Google's search engine in jeopardy. I'd be surprised if Google doesn't come out one of these days to announce they're partnering with IBM to enhance their search engine.

IBM invented the cloud twnety years ago and they're inventing cloud 2.0 now.

Please leave your comment:


Get WordPress Plugins for easy affiliate links on Stock Tickers and Guru Names | Earn affiliate commissions by embedding GuruFocus Charts
GuruFocus Affiliate Program: Earn up to $400 per referral. ( Learn More)
Free 7-day Trial
FEEDBACK