When Mohnish Pabrai met Charlie Munger in 2007, he said to Mohnish that an investor could improve his results dramatically by following three recommendations: checking out what other great investors are doing, buying the cannibals and looking at spin-off situations.
The cannibals are those companies that buy back tons of their own shares. As a result, equity holders increase their ownership at the company. Because the number of available outstanding shares in the market decreases, it's also a way to improve EPS and unlike dividends, it's also a non-taxable form for investors of reinvesting company's proceeds; if share buybacks are done below intrinsic value, results are accretive for stake holders.
My interest in IBM started once Berkshire Hathaway (BRK.A)(BRK.B) bought a huge stake in Big Blue, acquiring more than 68 million shares since first quarter of 2011, a 5.5% stake, at an average price of USD$170.
After BRK's position was disclosed, Warren Buffett went on CNBC to explain plainly his reasons for placing such a huge bet on IBM, which were essentially those that complete the three-legged stool of Berkshire criteria for long-term holdings (wide moat, high ROIC business, management in place, staying power). In summary:
- Buffett did not speak to IBM's management prior to the buy, but he had been reading its annual reports for 50 years while it was under the reigns of both Lou Gerstner, who rescued the company from bankruptcy, and Sam Palmisano, who left the company in 2012. In October 2011, he and the board blessed Ms. Virginia Rometti as his successor. Ms. Rometti, who was at that time executive VP, held a remarkable acumen of the company throughout her 30-year trajectory, leading the integration of Price WaterhouseCooper Consulting.
- IBM has been tracing and executing a Roadmap for years; the company duly reports to shareholders how and when it is going to execute its strategy.
- Buffett checked with BRK's subsidiaries and IT managers about IBM, and he found out about its stickiness; it's pretty difficult to get out of it once it is part of your IT systems. IBM has been able to build close relationships with its customers, so Buffett thinks IBM has the staying power he asks for his long-term holdings. IBM is a business service and consulting company, not a pure tech play.
- Buffett liked IBM's prudent and friendly shareholder's capital allocation through dividends and huge stock buybacks.
Two Years Later, Mr. Market Has Changed Its Mind About Big Blue
Buffett bought IBM at close to 52-week highs in 2011 at an average price of US$170 per share. Almost two and a half years later, IBM's shares are languishing close to 52-week lows around US$180 per share, clearly trailing Mr. Market as a whole.
Sell Side Is bearish on IBM
One of the most prominent sell-side institutions, which has downgraded IBM twice in the last six months, is Credit Suisse. It is pretty skeptical about IBM's future prospects, and it is convinced that Big Blue is set to underperform.
Credit Suisse downgraded IBM on August 2013, and it recently cut the objective share price to US$160 per share. Its reasoning was based on poor organic revenue growth, shrinking market share, cash flow conversion issues and balance sheet debt load.
If we check the evolution during the last quarters, we can highlight these figures:
|
| Revenues | Gross M | Op Margin | CFO | FCF (*) | Shares Out(***) | EPS(**) |
| 2010 | 99,87 | 46,05% | 19,74% | 19,54 | 16,3 | 1287 | 11,67 |
| 2011 | 106,91 | 46,9% | 19,80% | 19,84 | 16,6 | 1213 | 13,44 |
| 2012 | 104,50 | 48,1% | 20,95% | 19,58 | 18,18 | 1155 | 15,25 |
| 2013 | 99,8 | 48,6% | 19,6% | 17,48 | 15,02 | 1103 | 16,28 |
Revenues / Cash flow from operations / Free cash flow, figures in billions
(*) IBM FCF estimations = CFO- change in GF receivables-capex
(**) EPS, IBM operating-non GAAP earnings per share reference,
(***) Non diluted shares outstanding, figures in millions.
At first glance, we can see that revenues CAGR are almost flat, and that increments in bottom-line EPS basically came from margin expansion and buybacks; all in all it seems that IBM is having a pretty hard time trying to expand its revenues, although investors have seen operating EPS increasing at a CAGR of 11.73% for the last three years.
So, while pundits are totally right in pointing out stagnant revenues, IBM managed to significantly increase EPS since 2010.
We will try to offer a closer picture of IBM's segments' evolution.
| GTS | GBS | Software | Systems | Financing (*) | TOTAL | |
| 2010 | ||||||
| Revenues | 38,2 | 18,22 | 22,48 | 17,97 | 2,23 | 99,12 |
| % Revenues | 38,54% | 18,38% | 22,68% | 18,13% | 2,25% | |
| Pre tax income | 5,49 | 2,54 | 9,46 | 1,45 | 1,95 | 20,92 |
| % Total income | 26,24% | 12,14% | 45,22% | 6,93% | 9,32% | |
| Pre tax margin | 14,37% | 6,65% | 24,76% | 3,80% | 5,10% | |
| 2011 | ||||||
| Revenues | 40,87 | 19,28 | 24,94 | 18,98 | 2,1 | 106,94 |
| % revenues | 38,22% | 18,03% | 23,32% | 17,75% | 1,96% | |
| Pre tax income | 6,26 | 3 | 9,97 | 1,63 | 2,01 | 22,9 |
| % Total income | 27,34% | 13,10% | 43,54% | 7,12% | 8,78% | |
| Pre tax margin | 15,32% | 7,34% | 24,39% | 3,99% | 4,92% | |
| 2012 | ||||||
| Revenues | 40,23 | 18,46 | 25,44 | 17,66 | 2,01 | 103,93 |
| %revenues | 38,71% | 17,76% | 24,48% | 16,99% | 1,93% | |
| Pre tax income | 6,96 | 2,98 | 10,81 | 1,22 | 2,03 | 24,01 |
| % Total income | 28,99% | 12,41% | 45,02% | 5,08% | 8,45% | |
| Pre tax margin | 17,30% | 7,41% | 26,87% | 3,03% | 5,05% | |
| 2013 | ||||||
| Revenues | 38,6 | 18,4 | 25,9 | 14,4 | 2 | 99,8 |
| %revenues | 38,68% | 18,44% | 25,95% | 14,43% | 2,00% | |
| Pre tax income | 6,98 | 3,21 | 11,1 | 0,5 | 2,17 | 22,96 |
| % Total income | 30,40% | 13,98% | 48,34% | 2,18% | 9,45% | |
| Pre tax margin | 18,08% | 8,32% | 28,76% | -1,30% | 5,62% |
(*) Financing pre-tax income margin, includes results from both external and internal revenues.
If we stick to the numbers above, we can identify Systems as a laggard for IBM's performance. In 2010 this division contributed 18.13% of total revenues and 6.93% in pre-tax income; in 2013 it accounted for only 14.4% of total revenues while pre-tax income was negative.
While it's remarkable that IBM's total revenues during 2013 have been $4 billion less than in 2012, 75% of lost revenues in 2013 are due to the Systems division; this IBM "leg" is the less profitable one, with operating margins of only 3% to 4%.
On the other hand, GTS (Global Tech Services) and GBS (Global Business Services) revenues are flat since 2010, although operating income has improved for the last four years because of better margins; operating income for Global Services division was roughly $8 billion in 2010 and $10.3 billion in 2013.
The trend for Software, which is the more profitable divisio,n is positive; revenues in 2010 accounted for 22.68% out of total. This division's outcome reached 45.22% of total operating profit, with a 24.6% operating margin, the figures for 2013 have been 25.05%, 48.34% and 28.76%, respectively.
So far, operating income in the Software division was $9.46 billion in 2010 vs. $11.1 billion in 2013.
So, while it's crystal clear that IBM's organic growth has been deceptive as critics have been pointing out, most of it is due to its less profitable and capital intensive division. Alternatively, IBM execution has been rather successful in Global Business and Software units, partially because of productivity improvements.
IBM's management seems to be aware about this situation; recently IBM reached an agreement with Lenovo, in order to sell IBM's 86x server business for $2.3 billion. IBM will keep System z mainframes, Power Systems, Storage Systems, Power-based Flex servers and PureApplication.
This transaction seems to fit into IBM's strategy, which is divesting from non-core assets in order to re-invest in higher margin activities.
IBM's Cash Flow Problems
Cash flow seems to me like a temporary setback. IBM's CFO (Martin Schroeter) exposed his position in relation to FCF during the third-quarter results presentation:
"This quarter, we generated $2.2 billion of free cash flow, down $900 million year to year. There were three key drivers of the year-to-year decline, higher workforce rebalancing payments from the second quarter program, changes in sales cycle working capital, and our operational performance. Through the first three quarters of the year, we generated $6.6 billion, which is down $2 billion yearto- year."
So, while the cash flow was partially affected by weaker operational performance, IBM's FCF was impacted by changes in working capital (receivables, excluding receivables from global financing, that are considered by IBM as "an investment that generates returns") and the cash payment for a workforce layoffs settlement that was shown up on previous quarter income statement.
Last but not least, during last quarter's earnings call, the CFO explained that free cash flow realization was in the range of 90% on a structural basis:
"But I would like to also spend a minute on free cash flow from a model perspective. From a model perspective we finished last year, if I were to look at free cash flow on a ratio basis, say, to net income on a free cash flow realization basis, we finished the year in the low-90s on a realization basis." (Source: International Business Machines Corp. (IBM) Q4 2013 Earnings Call)
We will check the figures provided by IBM, based on 2012's 10-K and recent press release of the full-year report for 2013.
|
| FCF (*) | Shares Out(***) | EPS(**) | FCF per share | % cash conversion |
| 2010 | 16,3 | 1287 | 11,67 | 12,66 | 108,48% |
| 2011 | 16,6 | 1213 | 13,44 | 13,66 | 101,64% |
| 2012 | 18,18 | 1155 | 15,25 | 15,74 | 103,21% |
| 2013 | 15,02 | 1103 | 16,28 | 13,61 | 83,60% |
The results for 2013 are lagging previous years, but it seems that with such a solid financial model, temporary issues should be fixed in 2014.
IBM's Debt Load
When I looked up at IBM financial documents, that's exactly what I thought, but actually IBM is a debt-free company. (Source)
Non-global financing debt totals $12.2 billion, while cash and equivalents amount to $11.1 billion.
The amount of debt ($24.5 billion in 2012) tied to Global Financing Services, which is leveraged at a 7 to 1 debt-to-equity ratio, is used for financing creditworthy customers (bad debt expenses were close to meaningless in 2012 for a total amount of $50 million); these customers use the loans to contract IBM's services. So, less than 30% of total debt is tied up in IBM's core operational business, and it's offset by the cash held on the balance sheet.
For the most part, the (80%) debt rate is fixed, averaging an interest rate of 3.43% in 2012, according to 2012 annual report data.
Why IBM Is a Strong Company
In this post, I've tried to go through several warnings that analysts have raised. It's true that IBM's organic revenues are flat, but I think that they will overcome the challenge and be more concentrated in higher margin, lighter capital sectors.
IBM had some cash flow issues during the third quarter that harmed its cash generation, but I think it is temporary, rather than structural.
IBM has a fortress balance sheet, although it's not comparable to other companies like MSFT and AAPL holding a real cash hoard in their balances. On the other hand, IBM is much better at optimizing its balance sheet resources than its peers.
Now, I will expose some aspects of IBM's that Mr. Market seems to be ignoring or overseeing.
1) Recurring Revenues
Excerpt from IBM's 2012 annual report, page 23:
"Global Services is a critical component of the company's strategy of providing IT infrastructure and business insight and solutions to clients. While solutions often include industry-leading IBM software and systems, other suppliers' products are also used if a client solution requires it. Approximately 60 percent of external Global Services segment revenue is annuity based, coming primarily from outsourcing and maintenance arrangements."
Excerpt from IBM's 2012 annual report, page 24:
"Approximately two-thirds of external Software segment revenue is annuity based, coming from recurring license charges and ongoing post-contract support. The remaining one-third relates to one-time charge (OTC) arrangements in which clients pay one, up-front payment for a perpetual license."
So, around 85% of IBM's revenues and 90% of its profits are recurring in a very significant percentage. That results in a massive backlog of more than $140 billion and enables IBM as a company deeply embedded in the core IT systems of its customers.
Bears argue that cloud computing is a game changer for IBM, due to the fact that its recurring revenue base and customer stickiness depends primarily on IBM's capacity as a provider for IT infrastructure, servers and storage, and that may change with the migration to cloud computing shared infrastructures making a dent in IBM's profitability.
Actually IBM has been investing heavily in cloud computing systems for the last two years by acquiring several companies like Worklight, Cast Iron and Greenhat. But most the exciting IBM acquisition in the cloud space was announced in June 2013; IBM bought Softlayer for $1.3 billion. Softlayer was considered to be the biggest private player in IAAS, serving more than 21,000 customers.
IBM expects to reach sales of $7 billion in annual revenues in this area and considers cloud computing as a fundamental asset in its vast integrated services offerings.
2) IBM's 2015 Roadmap Execution Is on the Way
IBM's operational EPS have been steadily growing at 11% CAGR since 2010, and operational non-GAAP EPS for 2013 is USD6.28. IBM forecasts EPS of USD18 per share in 2014 and USD20 in 2015. Big Blue needs some improvement on top-line revenues. During the last four years it has increased EPS, based almost solely in productivity improvements and huge share buybacks.
According to IBM's 2015 roadmap, there will be three major areas of improvement: incremental revenues from higher margin activities, productivity and cash returns to shareholders (dividends and share buybacks mostly).
As Warren Buffett pointed out, IBM is reliable when it comes to roadmap executions. In the last earnings call, the management seems to be fully commited to reach at least USD20 of EPS per share in 2015.
"As we enter 2014, we will continue to transform our business and invest aggressively in the areas that will drive growth and higher value. We remain on track toward our 2015 roadmap for operating EPS of at least $20, a step in our long-term strategy of industry leadership and continuous transformation."
3) IBM's Shareholder Friendliness Is Remarkable
IBM is a cannibal. It repurchased shares for $15.37 billion in 2010, $15.04 billion in 2011, $11.99 billion in 2012 and $13.9 billion in 2013; non-diluted shares outstanding were 1.29 billion in 2010 and 1.10 billion at year-end 2013, so they bought back 14.3% of outstanding shares. Hence, IBM paid $56.3 billion in order to retire 184 million shares.
Assuming an average price of USD180 during that period, IBM used approximately 60% of the amount settled for repurchases for buying back shares. The remaining 40% went diluted via stock remuneration programs (mostly through restricted stock units or RSUs instead of stock options) and acquisitions; this dilution is partially offset by the proceeds received from employees when they exercised their stock grants and the deferred taxes derived from share-based compensation.
We can compare that to Microsoft (MSFT) and Cisco (CSCO) as a proxy for big tech corporation buybacks. The giant from Redmond according to its 2012 10-K, had 8593 million diluted average shares outstanding in 2010, 8506 million in 2011 and 8470 million in 2012. Mr. Softy repurchased shares during that period for $11.55 billion, $5.02 billion and $5.36 billion, respectively.
So MSFT bought back 123 million shares for a total amount of $21.93 billion, assuming an average price of USD25 per share. MSFT, as a matter of fact, used actually only $3.07 billion out of $21.93 billion for "friendly shareholder" practices. That's just 14.5% or 85.5% dilution! Otherwise, we could say that MSFT paid $21.93 billion out of shareholders' pockets to buy back 123 million shares at an average price of USD178.29!
We know we should look into M&A and sum up the proceeds from tax shelters and employees, but the dilution is staggering.
Cisco Systems allocated $19.52 billion for share buybacks during the same three-year period, and initial diluted shares outstanding were 5.848 vs. 5.404 million at year-end 2012. Therefore, excluding M&A, proceeds from stock awards and tax shelters, it bought back 444 million shares at an average price of USD44 per share. It's a much better deal for shareholders than MSFT, but not as good as IBM.
On the other hand, since 2000, IBM used $149 billion (including $123 billion in share repurchases) in rewarding shareholders, and only $33 billion on M&A. Therefore, IBM is focused on returning proceeds to shareholders and leaving less room to non-accretive acquisitions (i.e. HPQ buying Autonomy, or MSFT with almost a 100% goodwill impairment of $6.2 billion in Equantive).
Is Warren Buffett's Investment Thesis on IBM Still Intact?
"The stocks I'm talking about have got just as much chance of going down tomorrow as up tomorrow. But we like the businesses over a five or 10 years stretch." — Warren Buffett
From my perspective, IBM is suffering some temporary setbacks that will be fixed in the course of the next years, a wide moat built mostly on switching costs, an integral scope of services, a global footprint and a business model with a recurrent stream of cash flows.
IBM's shareholder friendliness is clearly above average and unparalleled in the big tech world, and its balance sheet is better than it seems at first glance.
This post is not about valuation. From my point of view, if IBM is able to reach USD20 in EPS in 2015, and using conservative P/E multiples between 13 and 15, shares would be eventually trading between $260 and $300 by then; if we consider IBM as a long term holding, a lower valuation would be welcome while IBM is "eating" itself, so that shareholders to get a bigger piece of equity cake.
Disclosure: this post is not a buying recommendation. LONG IBM. This article reflects the author's personal opinion and may contain mistakes or inaccuracies.
Also check out: Warren Buffett Undervalued Stocks Warren Buffett Top Growth Companies Warren Buffett High Yield stocks, and Stocks that Warren Buffett keeps buying
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Portfolio14 - 5 hours ago Comment on Jeff Matthew's thesis?
http://jeffmatthewsisnotmakingthisup.blogspot.com.au/2014/01/ibm-ive-been-manipulated.html
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