Monday, October 21, 2013

IBM and The Return of Capital Story

IBM's stock has lagged the broader market this year, and last week did not help.

After reporting third quarter revenue figures that did not match expectations, and earnings that were better than Street estimates mostly due to a lower tax rate, IBM shares moved sharply lower, and now stand -10% lower than a year ago.

Most analysts who had rated IBM a "buy" quickly downgraded the stock.  Goldman Sachs was typical of the trend, as this excerpt from CNBC explained:

Part of IBM's appeal has been relatively steady earnings growth despite uncertainty in corporate tech spending. But that looks to be undergoing a change, at least for a while, according to Goldman Sachs. 

Downgrading IBM stock to neutral from buy, the firm wrote in a research note that "the company appears to be going through a challenging period that may limit operating earnings upside and produce more quarterly volatility than investors have been accustomed to." 
The problem stems from IBM's increasing reliance on emerging markets, Goldman said. While they accounted for nearly a quarter of its revenues and drove 80 percent of its revenue growth from 2010 to 2012, those markets are stagnating, with constant currency growth of only 1 percent in the first quarter, the brokerage added. 

http://www.cnbc.com/id/100873331

IBM now trades at less that 10x 2014 earnings estimates, which is slightly below its long term averages, and pays a 2.2% dividend yield.

At an internal meeting last Thursday, the consensus seemed to feel that we sell the stock.  The trend of disappointing quarterly earnings reports has frustrated  investors, and they despair at seeing better results in the near term.

While I must confess that I was initially inclined to agree with the group's consensus, after further reflection and work I think IBM is closer to a "buy" than any other rating.

Here's why:

While it is true that IBM is a technology company, its service business - installation and maintaining the technology "plumbing" for a wide variety of business and government entities - has been the driver of the company for the past couple of decades.

Lou Gerstner was the CEO in the early 1990's when the company started its transformation from a seller of "big iron" (i.e. large machines) to providing a holistic approach to technology.  Gerstner wrote one of the best business books out there (in my opinion) named Who Said Elephants Can't Dance? about the experience, if you are interested.

Gerstner's business insight was brilliant.  He recognized that most CEO's are not really all that interested in technology. They have a business to run, and technology is a tool - a crucial tool, to be sure - to provide the goods and services that they eventually want to sell.

IBM was the leader in developing a services model, but today most other large technology companies are trying to do something similar (see:  Hewlett-Packard and Oracle).

The best part about selling services instead of just peddling equipment is the "stickiness" of your contracts.

Once IBM becomes the selected vendor for a company, its efforts become part of its DNA.  Could it be replaced?  Sure, but not without a lot of money and expense.

For example, a client last week told me that his company will be replacing its legacy IT system (not IBM).  It will cost his firm $100 million, and require hiring 75 more IT professionals, to make the change, which is scheduled to take two years to complete.  Changes occur, but they are disruptive.

But the real key to the IBM story, in my opinion, is that it has become a "return of capital" story rather than a pure technology decision.

In 2010 the company announced a target of $20 per share by 2015.  This was double the $10.01 per share that Big Blue earned in 2009, but the company felt that its goal was very achievable.

It wasn't just its business model, but also its approach to creating shareholder value.  Yes, IBM planned on making numerous acquisitions and making other strategic moves to enable the company to maintain its tech leadership position.  However, the company also committed to a $50 billion share buyback program over the next 5 years, which would boost EPS and book value per share even if revenue and earning were flat.

This caught the eye of a pretty well-known investor from Omaha:  Warren Buffett.

In 2011 Buffett startled the business world by spending $10.7 billion of Berkshire Hathaway's cash hoard to buy 64 million shares of IBM, which represented 5.5% of the company.  He was challenged in an interview about the investment, as this excerpt from a CNBC interview on November 14, 2011, shows:

JOE: ...it's interesting with IBM how many times I've read that their top-line growth, they haven't had any for 10 years, and the only way they get earnings per share to go up, they're buying back stock so they're reducing the number of shares outstanding. So EPS goes up and it's all financial sleight of hand. They've moved some facilities offshore so they've got a lower tax rate. Every time they beat expectations or had higher earnings, I always saw the analysts say, yeah, but it was because there's fewer shares outstanding and because of a lower tax rate. It was—and it's amazing that after all that, here we are with you at this very bullish case.

BUFFETT: Yeah. And, Joe, there's nothing wrong with fewer shares outstanding.

JOE: No.

BUFFETT: If they get it down to where there's 64 million shares outstanding, I'll be very happy.

http://www.cnbc.com/id/45290263

In other words, even at the time of purchase, Buffett was making the conservative assumption that the revenues of IBM would be essentially flat for the coming years.  Because of the stickiness of their business model, this seemed reasonable.

What he was banking on (and I assume that he is still an owner) is that IBM management will continue its aggressive stock buyback program, and that it will make its 2015 financial targets.

So far IBM continues to buy shares.  At the end of 2009 there were 1.3 million shares outstanding, but today this count is down to 1.1 million.  The drop in share price, and the continued growth in cash flow (scheduled to be around $19 billion in 2013 despite the tepid revenue trends) mean there is little reason to expect management to stop its share buybacks.

At the present rate, the number of shares outstanding by the end of 2015 should be around 900 million, or a -30% decline over 5 years.  Even if revenue remains around today's level of $100 billion, EPS should be well above $20 per share in 2015. 

Although shares are trading at less than 10x earnings today, the 5 year average multiple has been 12x.  Applying 12x to $20 EPS gives a stock price of $240, or about +40% higher than current levels.

There are risks, of course:  IBM could suffer major contract reversals, for example, or the world economy could take a sudden plunge lower which would hurt its global business.

But buying a high quality stock at depressed valuations is usually a pretty profitable idea, and this seems to be the case with IBM today.

This is what Buffett wrote in the 2011 annual report, and it bears a re-read today:

Let’s use IBM as an example. As all business observers know, CEOs Lou Gerstner and Sam Palmisano did a superb job in moving IBM from near-bankruptcy twenty years ago to its prominence today. Their operational accomplishments were truly extraordinary.
 
But their financial management was equally brilliant, particularly in recent years as the company’s
financial flexibility improved. Indeed, I can think of no major company that has had better financial management, a skill that has materially increased the gains enjoyed by IBM shareholders. The company has used debt wisely, made value-adding acquisitions almost exclusively for cash and aggressively repurchased its own stock.
 
Today, IBM has 1.16 billion shares outstanding, of which we own about 63.9 million or 5.5%.
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. Our quiz for the day: What should a long-term shareholder, such as Berkshire, cheer for during that period?
 
I won’t keep you in suspense. 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
million more than if the “high-price” repurchase scenario had taken place.
 
The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions , however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day’s supply....
 
In the end, the success of our IBM investment will be determined primarily by its future earnings.  But an important secondary factor will be how many shares the company purchases with the substantial sums it is likely to devote to this activity.
 
http://berkshirehathaway.com/letters/2011ltr.pdf