Recently there has been a lot of criticism and doubts with regards to Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial)'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, Financial).
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.