1. How to use GuruFocus - Tutorials
  2. What Is in the GuruFocus Premium Membership?
  3. A DIY Guide on How to Invest Using Guru Strategies
Grahamites
Grahamites
Articles (328) 

IBM: A Reality Check on Thinking and Investment Process – Part II

April 08, 2015 | About:

In my previous article, I took the chance and reflected upon what I learned, and how my thoughts have changed since I wrote the two IBM (NYSE:IBM) articles during 2014. I wrote the following provocative statement towards the end of the article: “I’m not sure how many investors would have bought IBM if Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) had not been a shareholder.” The reason why I made this statement was hinted in my conclusion sentence of the article: IBM’s business is too complicated and there are a good amount of disconfirming evidences.

Let me first clarify that I think there is a lot to like about IBM. I am not against it at all. My intention for writing this article series is not to reinforce what everyone already knows, but hopefully, to provide another angle in looking at IBM.

For me, I have ruled IBM out of my circle of competency after reading IBM’s annual reports for the past 25 years, a few books on the history and the business of IBM as well as the recent investor presentations and earnings call transcripts of IBM.

In one of my previous articles, I wrote the following criteria in terms of ruling a business out of my circle of competency:

I know a business is within the boundary of my circle of competency if:

  1. I understand the business model,
  2. I understand the most important factors that will make the business succeed or fail in the long run, and
  3. I can come up with reasonably good assessment of how these factors will play out in the next 5-10 years.

I went through the exercise with IBM.

IBM has 5 business segments –

  • Global Technology Services (GTS) primarily provides IT infrastructure and business process services.
  • Global Business Services (GBS) provides IT consulting and application management services.
  • Software consists primarily of middleware and operating systems software.
  • System and Technology is the hardware, systems, storage and semiconductor business.
  • Global Financing is the financing arm of IBM.

The financing segment is obviously the non-core business so we can take it out for the purpose of our discussion. GTS,GBS, Software and System and Technology each has its own business model, each one of them is complicated because each segment has vastly different competitive dynamics, is subject to different product cycle and service cycle and has totally different economics.

Let’s start with the service business, which includes GTS and GBS. They have been the big money makers for IBM since Lou Gerstner took over IBM in the early 1990s. GTS and GBS used to deserve their success because when Lou Gerstner built the service division, he made sure the service teams knew very well how to implement technology, how to support manage the projects, how to listen to the customer and how to get the results. However, things get more complicated as Sam Palmisamo and Ginni Rometty started to relentless cut cost by massive layoffs and sending works offshore. It is widely known that Sam Palmisamo laid out this 2015 roadmap for IBM while he was in charge. One of the goals was to achieve “at least $20 operating EPS by 2015.” In order to achieve this goal, management has to cut cost if revenue is stagnant. They have to cut more costs if revenues are falling. The consequences are gradual but real. Service quality has been compromised in order to the make the profit goal, which hurts IBM’s reputation, which hurts the hardware and software business as IBM needs the Services division to help sell its hardware and software.

Moving on to the System and Hardware business, during the Q4 2014 earnings conference call, IBM’s management talked about the product cycle of System z. According to the management team, IBM was in the 10th and final quarter of the product cycle for System z. IBM spent five years and $1 billion on the new System z13. IBM has also divested System x to Lenovo. I knew very little about the System z product cycle or System x. So I found it extremely hard, if not possible to assess whether the divestiture was good decision or not even though I’ve read a lot about IBM.

I’ve also read from a book called “The Decline and Fall of IBM” that a technology called “unified computing will soon be able to build systems to replace IBM's greatest mainframes for a fraction of the cost. The Technology called Hadoop has application to storage and other elements of IBM’s hardware businesses. Soon IBM’s unique or proprietary technology will not be enough for it to complete in the market place.” I don’t know enough to assess whether this statement is true, but if it is true, then IBM’s hardware business will be facing some serious challenges.

The Software business is even more complex than the Services Business and Hardware business. It consists primarily of middleware and operating systems software. Within the Software segment, there are seven specific capabilities – WebSphere, Information Management, Tivoli, Watson, Workforce, Rational Support and Mobile. I think it is safe to say that any non-technology background investor would have a hard time understanding these capabilities and assessing IBM’s competitive advantage in each of them, or on aggregate.

To make things more complicated, IBM’s management has added another layer of complexity by coining up the concept of those so-called “Strategic Imperatives,” which include Data, Cloud, Analytics and System of Engagement. These strategic imperatives are what management believes the future of IBM but yet they have revenue streams impacting all segments, but mostly Software.

Let’s walk through an example. Here are the components of IBM’s SmartCloud:

While the tenet is obviously as-a-service but there are four of them. In order for you to assess the competition, IBM's position and to project what the future is likely like for IBM’s cloud, don’t you have to at least understand the market in each of these as-a-service-area? Let’s start with PaaS, or Platform as a Service. I do not have a technology background so I have to learn everything from the ground up. In simple terms, PaaS provides developers a platform for them to develop apps or cloud-based software. Obviously IBM is not the only one in the space. Microsoft and Google are both IBM’s competitors with Microsoft’s Azure and Google’s App Engine. I have the faintest idea why would a customer would choose IBM over Microsoft or Google.

Ditto to IaaS or SaaS. In IaaS, IBM competes against Amazon, Rackspace and others. I really don’t know how to assess IBM’s competitiveness. You can take management’s words and just believe IBM has a huge competitive advantage in all the areas, but I think it is very dangerous believing what management says without knowing why.

Aside from the complexity in IBM’s business model in each of its segment, another layer of complexity comes from the rapid change in technology that IBM’s business is subject to. Yes, IBM has shifted its business model from a hardware-centric to a software-centric one. Yes, the margin profile is much better now. However, one of the consequences, which I think very few people take into consideration, is that a software-centric business model is also more vulnerable to much more rapid technological changes. This is certainly true for all those strategic imperatives IBM has listed. IBM is trading higher margin for more uncertainty.

Then there is the complexity of IBM’s culture and structure. IBM itself, aside from the businesses, is a pretty complicated fellow. The organization is hierarchical, and the culture has changed gradually and slowly since Gerstner took it over in the early 1990s. I would not be surprised if IBM is subject to what Warren Buffett (Trades, Portfolio) calls the ABC symptom – Arrogance, Bureaucracy and Complacency. The trouble with this level of complexity is that you can imagine very often simple problems or decisions can get very complicated due to the organizational structure and culture. In a world where things change rapidly, this is certainly not ideal.

Now let me get back to my three questions regarding circle of competency?

1. Can I understand the business model? Barely.

2. Can I understand the most important factors that will make the business succeed or fail in the long run? No.

3. Can I come up with reasonably good assessment of how these factors will play out in the next 5-10 years? Absolutely no.

I am not saying that IBM is not understandable. I just think there are a lot of important moving pieces, and it is too complicated for me. I probably could spend a few more months and maybe a few more years to really understand the business, but the opportunity cost is too high. I’d rather move on to the companies I can understand as opposed to trying to figure out what Mr.Buffett sees that others don’t see.

There is nothing wrong with admitting I don’t know and acting accordingly. There is nothing wrong with missing out on something you don’t understand. But to follow Mr.Buffett without knowing why, is perilous in my opinion.

About the author:

Grahamites
A global value investor constantly seeking to acquire worldly wisdom. My investment philosophy has been inspired by Warren Buffett, Charlie Munger, Howard Marks, Chuck Akre, Li Lu, Zhang Lei and Peter Lynch.

Rating: 5.0/5 (20 votes)

Voters:

Comments

Sam Pang
Sam Pang - 4 years ago    Report SPAM

thanks for the insights.

Thomas Macpherson
Thomas Macpherson premium member - 4 years ago

Great article. Excellent writing and very clear. This is the kind of writing which will make GuruFocus a world leader in value investing. Thanks so much for posting. - Tom

batbeer2
Batbeer2 premium member - 4 years ago

Thanks for an interesting article.

You say:

>> Obviously IBM is not the only one in the space. Microsoft and Google are both IBM’s competitors with Microsoft’s Azure and Google’s App Engine. I have the faintest idea why would a customer would choose IBM over Microsoft or Google.

Here's a thought.

Watson is a very important part of IBM's framework. The interesting thing about Watson is that it learns. Watson was not programmed but trained to win Jeopardy.

As a programmer, imagine you had to come up with the software to play Jeopardy and win. That would be a big job for a large team of very smart programmers.

BUT

With IBMs cloud/framework you can create relatively simple apps that you can then "train" to do very complex tasks.

For example, IBM can ask 20 very good pilots to put in an effort and spend a few weeks "training" an app specifically targetted at pilots (or doctors or lawyers) and then that app can be used by thousands of others. What's more, the app learns from mistakes and gets better and more valuable over time..... with very little additional input on the part of the developper.

You can think of it as Apple's Siri but one that learns about your tastes and habits and also learns from the solutions others have (de)selected when they were in your situation. After you've used that for a few months, you find you're hooked. The app improves because it is used and not because the developper has spent millions creating a new version.

It is also a bit like the Google "Nest" thermostat. You do not program it but it learns from your habits and after a while you find you do not want to buy a new thermostat because it will take you weeks to "train" a new thermostat.

But unlike Google, IBM is not selling thermostats. Together with Apple, IBM is developping apps for lawyers, surgeons, pilots and other people with very high hourly rates. All these apps are leaning machines and if some/any of them catch on, then you have a big earnings stream with very little further investment (no teams of programmers). From the viewpoint of the users there are huge switching costs because a lawyer just can't afford to spend a few weeks "training" a new app to read and "understand" his case files.

Economically speaking would a Lawyer rather spend $1000 on a license for his vital app/assistant or two weeks/10 hours training a new one that came free?

That's the moat.

You'll note Watson is extremely good at reading millions of lines of complex/technical text and within seconds, find answers to complex/vague questions. That is how it won Jeopardy and that is something a lawyer can appreciate.

Yes, there are other AI platforms out there but AFAIK IBM is the only major/reputable player that is offering this commercially as a platform for developpers. That is why Apple has teamed up with IBM to bring this new stuff/intelligence to their hardware.

Another way to put is is that IT infrastructure/hardware is deflationary. You are never going to get a durable competitive advantage by offering a better/cheaper/faster hardware platform. Within a few years someone will come along and offer twice the capacity at half the price.

BUT

The cost of a good programmer is not deflationary. IBM offers the platform that requires the least effort on the part of the programmer to create a software solution for very complex problems. As the cost of the programmer becomes an ever greater part of the cost of a solution, IBM becomes the low-cost provider of complex software solutions.

Just some thoughts.

Grahamites
Grahamites - 4 years ago    Report SPAM

Kytad95 - Thanks for the nice words.

Grahamites
Grahamites - 4 years ago    Report SPAM

Tom - Really really appreciate it. I am flattered and horrified by your super nice words. Thanks for your support and thanks for all your inspiring articles.

Grahamites
Grahamites - 4 years ago    Report SPAM

Batbeer-

I am fairly familar with Watson. I agree with everything you said. It is without a doubt one of a kind. AI is the future, there is no doubt and Watson is years ahead of competition. I'm impressed with its performance in Jeoperdy and how it's being used in HealthCare and Financial services and I'm sure the potential is much more than where it is now.

But

1. If you look at the sell side reports, or IBM's website, or IBM's presenations, any of them. It is widely known. So anyone who has access to these already knows Watson is pretty awesome. Maybe they don't know the extent of its awesomeness but I think at least it is partially reflected in the price.

2. Then we have to quantify the impact of Watson for IBM. We see a lot of literacy but very limited numeracy.Last year I think Watson represents about 100m to 200m of IBM's revenue and the optimistic projection I saw is $2 billion in 2018. Obviously it can be much higher than that, how much no body knows but I agree Watson could be a big deal for IBM after 2017-2018.

So, yes, Watson is awesome and banks, hospitals, universities and etc. should use Watson. But what should happen may be reflected in the price and what should happen may fail to happen on time. I don't know.

Grahamites
Grahamites - 4 years ago    Report SPAM

And by the way, also agree IBM has a very wide moat. The moat is narrowing in some areas and widening in others.

batbeer2
Batbeer2 premium member - 4 years ago

Hi Grahamites,

You say:

But... If you look at the sell side reports, or IBM's website, or IBM's presenations, any of them. It is widely known. So anyone who has access to these already knows Watson is pretty awesome.

I say: ignore the crowd.

Going with the crowd (momentum) or going against it (contrarian).... either way your actions are dictated by the crowd. You will go crazy trying to outguess a fool. FWIW I believe the market is crazy because almost everyone in it is trying to outguess everybody else.

In other words, if you believe the market is irrational, why care about what it knows or doesn't know?

snowballbuilder
Snowballbuilder - 4 years ago    Report SPAM

@grahamites , i sometime disagree with you but this time i agree.

Also a really good , and well argued and detailed article.

As for me i m not going to buy ibm.

My personal view is that IT could probably be a good way to stay rich , but not to get rich.

Just my view , best snow.

kskarbeck
Kskarbeck - 4 years ago    Report SPAM

Here is why you buy IBM:

1) PE 10, 2) Price to cash flow 9, 3) shareholder oriented capital allocation, buying back tons of stock increasing your ownership 4) dividend 2.7% 5) high quality company

That it.

Grahamites
Grahamites - 4 years ago    Report SPAM

Hi Batbeer- Thanks for your comments. I always enjoy them because they make me think a lot. I like having intelligent discussions with an intelligent investor such as yourself:)

I think you might agree with me on the followings:

No.1 - To achieve superior returns, you have to think different and better, than "the crowd." So logically speaking, you need to know what the crowd thinks in order for you to have the average thinking to game against. And unless you have something different and better, maybe you should be the crowd.

No. 2 - I do believe the market is irrational, but not always. I think the market is actually pretty efficient most of the time. In other words, going back to the notion of crowd, I think the crowd is right very often. Market anticipates based on what the crowd thinks. It's remarkable even though the market is permeated with individual folly, once you average them out, you get a very reasonable expecation most of the time.

No.3 - Your action should not be dictated by the crowd, whether you go with the crowd or whether you go against the crowd. Your action should only be dicated by sound analysis after a deep-dive research and some serious and hopefully, better thinking. You are not trying to outguess the fool, you are trying to come up with an independent opinion. Sometimes your opinion may come up exactly the same as that of the fool and that's ok. Sometimes the fool knows better than you if you step out your circle of competency. And sometimes you come up with deserved better opinions. My hope is that over time, I'll come up with more deserved better opinions.

Therefore, I don't think we should ignore the crowd but that doesn't mean we should pay much attention to it either. I don't think the market is categorically irational but I do think superior thinking is absolutely needed in order to spot the moments when the market is irational.

Grahamites
Grahamites - 4 years ago    Report SPAM
Kskarbeck - Thanks for your comments. What you listed is bascially what I listed when I wrote my IBM article last year. I could repeatedly write you should buy IBM based on the numbers you listed in your comments

But it's not that easy.

Have you thought about why IBM is trading at 10 times P/E? What is the appropriate P/E for a business that is not growing, growing at 1%, 2%, 5% and 10%? Maybe IBM deserves a lower than 10 times P/E.

Then you should also think about whether buying back shares is the best capital allocation option? Jim Chanos (Trades, Portfolio) did a study and here is what he found: "the return on IBM's buybacks is about 6.5%. Not a terrible number. But IBM's return on what he dubs its "net business assets"—actual stuff used in actual business—is far better. It is 18.1%." Note that was in Jan 2014. The return on buyback is lower than 6.5% as of today for sure.

batbeer2
Batbeer2 premium member - 4 years ago

Hi Grahamites:

You say:

>> I think you might agree with me on the following: .... to achieve superior returns, you have to think different and better, than "the crowd." So logically speaking, you need to know what the crowd thinks in order for you to have the average thinking to game against.

Ehm..... no, I don't agree ;o)

For starters, I'm not interested in superior returns.

You rightly consider the IRR of a given portfolio superior if it exceeds some index/average.... but that is a choice. If you go down that road, I'll grant you it is logical to ponder the considerations of other market participants.

If however you don't go down that road, you have other options.

Case in point, I'm more interested in satisfactory returns. There are important differences between satisfactory returns and superior returns. There's an absolute but subjective return that I consider satisfactory. What's more, I consider the IRR of my portfolio as measured over a period of less than five years meaningless.*

Take it for what it is worth though. I have been picking stocks for roughly five years now so the above statement implies that my results so far are almost meaningless..... which is true. I've learnt a few things along the way though. Some of them from you, thanks.

In sum, you are perfectly right within one generally accepted framework.

My point is that there are other frameworks and within some of them the crowd is less relevant. Southeastern (Mason Hawkins) has an interesting one. Their benchmark is "inflation + 10%". Could this somewhat unusual benchmark affect the stocks they pick, the clients they attract and the kind of analysis they do as compared to a fund with the stated goal of beating an index?

Back to the topic.

Kskarbeck argues that the fact that IBM trades at P/E of 10 is one good reason to buy. You counter this by saying perhaps the multiple is "appropriate". This makes sense if you're thinking about what the market should be willing to pay for the company. That would be the "buy-low-sell-high" schism of the church of value investing.

If however you think IBM not as a stock trading at a P/E of 10 but as a stock with an earnings yield of 10%, then the next logical step is to decide whether you deem that yield satisfactory and sustainable. If indeed (as per Chanos) IBM is able to put some of those retained earings to work at 18% IRR and then use the rest to buy back stock at 6.5% IRR then IBM's earnings are not only sustainable, they will grow at a decent rate. That's not a terribe thing to own.

I would label this the "think-like-an-outright-owner" schism of the church of value investing.

Two different frameworks/approaches, both grounded in solid data and both will rule out expensive stocks. But the second one enables you to reach a rational conclusion without giving much thought to what the market is or should be thinking.

Just some thoughts.

* With the exception of a negative 100% IRR within a given year which I'll admit is a meaningful short-term result ;o)

Grahamites
Grahamites - 4 years ago    Report SPAM

Batbeer:

Absolutely agree aiming for superior returns and aiming for satisfactory returns is vastly different, although the general value investing framework applies. There are a lot of things that work in investing, what you said may be perfectly true, they sound logical to me. We all have our own philosophies shaped by our own learnings and experiences, one doesn't preclude the other. The important thing is staying rational and disciplined. Maybe we can both agree on that:)

Back to IBM. I probably should be more clear that the appropriate multiple also depends on the confidence level you have on your projections, and the required rate of return. So it should be different among you, me and Kskarbeck. I'm not suggesting the appropriate multiple is what the market should be willing to pay for the company. Not to counter-argue, but to clarify.

batbeer2
Batbeer2 premium member - 4 years ago

>> The important thing is staying rational and disciplined. Maybe we can both agree on that:)

Yes.

jtdaniel
Jtdaniel premium member - 4 years ago

Hi Grahamites,

Thanks for two quality articles on IBM. It makes perfect sense to pass on any investment if you lack complete confidence, no matter who else likes it. I made the same call on GE, as I was just never comfortable with my valuation. Actually, I think Mr. Buffett would applaud your decision, as he believes in concentrating on your high-conviction ideas. That said, I find no fault with those who see a wide moat, low multiple, high ROIC and Mr. Buffett's endorsement as an opportunity for profit. A few of us like to feel we know a business well enough to act for the CEO if necessary. That may say more about our personality traits than our likelihood of outperformance. Sometimes the simple metrics are all it takes to get the job done. Best, dj

varunfriend
Varunfriend premium member - 4 years ago

I have always thought part of "circle of comptence" should involve oneself .. and ones psychology. I prefer to run a more diversified portfolio which is margin of safety in of itself. FWIW - I am long IBM I genereally agree with everything said above. I am fairly diversified and aim to hold upto 30 -35 positions. So as a part of that portfolio IBM at this valuation and ROIC makes sense to me.

Batbeer - Not to add fuel to the fire ;) ...

http://www.toptechnews.com/article/index.php?story_id=030002HUM2UC

Amazon just launched Machine Learning as a service ... its a direct aim at Watson. To quote from the article:

"How powerful is Amazon Machine Learning? In 20 minutes, one Amazon developer was able to solve a problem that had previously taken two developers 45 days to solve.. It’s noteworthy that none of these developers had prior experience in machine learning, and both models posted 92 percent accuracy."

I am not saying that they can overthrow Watson but the competitve advantage maynot be as large as I had originally thought.

varunfriend
Varunfriend premium member - 4 years ago

I have always thought part of "circle of comptence" should involve oneself .. and ones psychology. I prefer to run a more diversified portfolio which is margin of safety in of itself. FWIW - I am long IBM I genereally agree with everything said above. I am fairly diversified and aim to hold upto 30 -35 positions. So as a part of that portfolio IBM at this valuation and ROIC makes sense to me.

Batbeer - Not to add fuel to the fire ;) ...

http://www.toptechnews.com/article/index.php?story_id=030002HUM2UC

Amazon just launched Machine Learning as a service ... its a direct aim at Watson. To quote from the article:

"How powerful is Amazon Machine Learning? In 20 minutes, one Amazon developer was able to solve a problem that had previously taken two developers 45 days to solve.. It’s noteworthy that none of these developers had prior experience in machine learning, and both models posted 92 percent accuracy."

I am not saying that they can overthrow Watson but the competitve advantage maynot be as large as I had originally thought.

batbeer2
Batbeer2 premium member - 4 years ago

@ Varunfriend

Thanks, I didn't know that.

At first glance it seems Amazon's platform processes structured datasets (databases). Watson reads unstructured data (wikipedia type plain text). But yes, it seems Watson now has a nerdy friend to talk to.

Thomas Macpherson
Thomas Macpherson premium member - 4 years ago

Hey Batbeer. Without getting into too much detail, Amazon is interested in both structured and unstructured data. They are doing a pilot with HMS where they are using both electronic health record structured data (A1C) and unstructured (physician notes). We are utilizing both Amazon on the clinical care side and IBM on the reimbursement side. Will be interesting to see how both perform over time. Hope this helps. Best. - Tom

batbeer2
Batbeer2 premium member - 4 years ago

@Thomas

Thanks! Indeed, we shall see.

Investor77
Investor77 - 4 years ago    Report SPAM

I have the same problem...it is a business I do not understand...and the fact that in the last earnings announcement (Q2) when an analyst asked "if strategic imperative are growing 30% but revenue is in CC flat would you agree that the core business is going down especially considering that revenue is flat only because the huge ciclical boost of mainframe? What is happening to the core business than?"...and the answer I didn't know if to cry or to have a laugh....he did not answer at all ...

Please leave your comment:



Performances of the stocks mentioned by Grahamites


User Generated Screeners


pjmason14Momentum
pascal.van.garsseHigh FCF-M2
kosalmmuse6
kosalmmuseBest one1
DBrizanall 2019Feb26
kosalmmuseBest one
DBrizanall 2019Feb25
kosalmmuseNice
kosalmmusehan
MsDale*52-Week Low
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)