In my previous articles, I invited the readers to do some dirt-digging and calculation and see how IBM’s performance stack up to the Oracle’s expectation. Today I will share my thoughts and findings, as we are in the 18th quarter since Berkshire’s initial purchase of IBM, close to the five-year mark.
The company has used debt wisely, made value-adding acquisitions almost exclusively for cash and aggressively repurchased its own stock.
Since 2011, IBM has added more than $13 billion in debt. We have to note that some of the debt went to the global financing division to finance the receivables. So what did IBM do with the debt? From 2011 to 2014, IBM generated about $54 billion free cash flow (Operating CF – capex – net acquisition) but returned $64 billion to shareholder through dividend and buybacks. Obviously, the deficit is financed by debt. Raising debt to buy back shares or to pay dividend is no easy math. I won’t go in depth for the sake of this discussion.
At the end of 2010, IBM has almost 1.29 billion shares outstanding. Today it’s about 955 million. This is indeed very aggressive.
Naturally, what happens to the company’s earnings over the next five years is of enormous importance to us. Beyond that, the company will likely spend $50 billion or so in those years to repurchase shares. We should wish for IBM’s stock price to languish throughout the five years. Let’s do the math. If IBM’s stock price averages, say, $200 during the period, the company will acquire 250 million shares for its $50 billion. There would consequently be 910 million shares outstanding, and we would own about 7% of the company. If the stock conversely sells for an average of $300 during the five-year period, IBM will acquire only 167 million shares. That would leave about 990 million shares outstanding after five years, of which we would own 6.5%. If IBM were to earn, say, $20 billion in the fifth year, our share of those earnings would be a full $100 million greater under the “disappointing” scenario of a lower stock price than they would have been at the higher price. At some later point our shares would be worth perhaps $1.5 billion more than if the “high-price” repurchase scenario had taken place.
IBM's earnings, unfortunately, have not met Buffett’s expectations so far. In 2011, IBM earned $21 billion pretax. This year IBM is likely to earn about $18 billion pretax. However, a declining IBM stock price has benefited Berkshire in the forms of higher ownership and higher owner’s earnings. The original 63.9 million in 2011 represents about 5.5% ownership. Today, due to the aggressive share repurchase, Berkshire’s same 63.9 million shares represents almost 6.7% of IBM’s ownership.
Even though IBM’s share price and earnings have declined, Berkshire’s owner’s earning from the portion of IBM’s earnings has increased slightly. In 2011, Berkshire’s share of pretax earnings was just below $1.15 billion on $21 billion pretax income, today it’s about $1.2 billion on only $18 billion of pretax income. Indeed, so far Berkshire’s share of those earnings would be greater under the “disappointing” scenario of a lower stock price than they would have been at the higher price. Had IBM’s share price been higher in the past few years (say $200), both Berkshire’s ownership percentage from that 63.9 million initial purchase and the owner’s earning would be lower.
IBM spent almost $40 billion on share repurchases in the three-year period from 2012 to 2014, well on track of exceeding the $50 billion predicted by Buffett if IBM keeps up the pace in 2015 and 2016.
If IBM were a private company, Berkshire’s owner’s earning from the original investment of $10.9 billion (assuming Buffett paid $170 per share) in IBM would be $300 million from dividend plus $1.2 billion from operational earnings on a pretax basis, and $225 million and $900 million for a combined $1.125 billion on an after-tax basis – a 10.3% after-tax return on investment. This is not fantastic, but definitely a lot better than what the naysayers have claimed, which was based only on IBM’s stock price. Better yet, both dividend and Berkshire’s portion of IBM’s earnings are likely to increase for many years to come, even if IBM’s earnings stay flat or even decline a bit. The rate of increase will pick up if:
- IBM’s earning power increases, or
- IBM’s stock price remains depressed and IBM aggressively repurchases shares.
You can see why as Berkshire shareholders, we should really cheer for a depressed IBM share price for years to come, if the fundamentals don’t deteriorate too quickly. But if you are a short or intermediate term IBM shareholder, you will need to have a different game plan and wish for different things.
