3 Reasons Buffett Blew It on IBM

The following piece is intended to shed greater light on the issues causing IBM’s current struggles, their potential persistence, and the key points underlying the bull and bear cases. Despite being a technology stock, IBM has Buffett’s fingerprints all over it. Buffett started buying IBM in the $170s in 2011 (IBM most recently closed near $158) and upped his position during Q4 2014. Is Buffett making a big mistake buying more shares of IBM, or should long-term dividend investors look to add or initiate a position?

 

Read on to learn if we think now is the time to add IBM to our notable Top 20 Dividend Stocks list.

 

What Does IBM Do?

If you are like me, understanding and analyzing big blue chip companies with sprawling operations, especially those involved in the technology sector, can be a bit of a challenge. With five segments and a business transformation underway, IBM is no exception.

 

IBM has been around for more than 100 years, operates in over 170 countries, and provides a variety of offerings – IT infrastructure services, consulting, software, and server / storage hardware.

 

After numerous divestitures and organic and acquisitive investment into more software and services, hardware revenue is down to 10% of total sales.

 

Much of the hardware revenue consists of mainframe computers, big, powerful, expensive, and super reliable computers that have been around for more than 50 years. Mainframes run huge jobs, such as managing the databases of an insurance company or credit card transactions of a bank and are increasingly relied upon for analytics thanks to their speed and power. Most people have never seen a mainframe, but here is a look at IBM’s newest refrigerator-sized model, which can process 2.5 billion transactions a day – the equivalent of 100 Cyber Mondays every day of the year:

 

 

While hardware is only 10% of IBM’s sales, it is important to understand that many of IBM’s other revenue lines revolve around the installation and maintenance of mainframes. For example, according to analysts, mainframe-related software and services account for over 30% of IBM’s operating profit and have been IBM’s bread-and-butter for decades.

 

Here is a full segment overview:

 

Global Technology Services (GTS – 40% of FY14 sales; 17% pretax margin): provides IT infrastructure and business process services. This segment primarily delivers IT outsourcing services to help improve clients’ existing infrastructure. GTS competes in strategic outsourcing, business process outsourcing, cloud services, and a wide range of technical and IT support services.

 

Global Business Services (GBS – 19% of sales; 16% pretax margin): provides consulting, systems integration, and application management services. As clients transform themselves in response to market trends like big data, social and mobile computing, GBS helps clients use these technologies to reinvent relationships with their customers and realize new standards of efficacy and efficiency across their businesses.

 

IBM’s services businesses compete with broad based competitors including: Accenture, Amazon, Computer Sciences Corporation, Fujitsu, Google, Hewlett-Packard and Microsoft; India-based service providers; the consulting practices of public accounting firms; and many companies that primarily focus on local markets or niche service areas.

 

Software (27% of sales; 37% pretax margin): consists primarily of middleware and operating systems software. Middleware software enables clients to integrate systems, processes and applications across a standard software platform to improve their business results. Operating systems are the software engines that run computers. Approximately 70% of external Software segment revenue is annuity based, coming from recurring license charges, software sold “as a service” and ongoing post-contract support. The remaining revenue relates to one-time charge arrangements in which clients pay one, up-front payment for a perpetual license.

 

The company’s principal competitors in this segment include CA, Inc., Microsoft, Oracle, Salesforce.com and SAP.

 

Systems and Technology (11% of sales; 0.3% pretax margin): provides servers and storage products to address capacity, security, speed and compute power needs for businesses and to allow clients to retain and manage rapidly growing, complex volumes of digital information. This segment has seen significant revenue declines in recent years due to product cycles, client losses, and certain clients migrating to the cloud.

 

The company’s principal competitors include Cisco, Dell, EMC, Hewlett-Packard and Oracle. Additionally, infrastructure-as-a-service providers such as Amazon Web Services who offer IT as a service and original device manufacturers who offer re-branded, lower cost system hardware alternatives compete with the company in this area.

 

Global Financing (2% of sales): facilitates IBM clients’ acquisition of information technology systems, software and services by providing financing solutions in the areas where the company has the expertise. For those studying IBM’s balance sheet, note that this financing arm accounts for $29.1B of IBM’s total book debt of $40.8B (as of 12/31/2014).

 

Why Did Buffett Buy in the First Place?

Buffett’s familiarity with IBM goes back a long ways – he says he has read every annual report since 1961. Essentially, his public comments suggest he was most attracted to IBM’s trusted brand name and the stickiness of its customer relationships:

 

“I imagine as you go around the world that there are – there’s a fair amount of presumption in many places that if you’re with IBM, that you stick with them, and that if you haven’t been with anybody, you’re developing things, that you certainly give them a fair shot at the business.”

 

…

 

“The IT departments, you know, we’ve got dozens and dozens of IT departments at Berkshire. I don’t know how they run. I mean, but we went around and asked them and you find out that there’s – they very much get working hand in glove with suppliers. And that doesn’t mean things won’t change but it does mean that there’s a lot of continuity to it… Now, I would imagine if you’re in some country around the world and you’re developing your IT department, you’re probably going to feel more comfortable with IBM than with many companies.”

 

IBM boasts an impressive customer lineup: more than 90 of the top 100 banks and the top 25 U.S. retailers run on IBM systems. In addition, nearly half of the Fortune 100 companies outsource IT operations to IBM.

 

In addition to IBM’s brand and customer relationships, Buffett probably felt some comfort from IBM’s intellectual property. IBM annually invests 6% of total revenue for R&D (a whopping $5.6 billion in 2014) and has the world’s largest mathematics department of any public company, enabling IBM to create unique analytic solutions and actively engage with clients on their toughest challenges.

 

In 2014, IBM was awarded more U.S. patents than any other company for the 22nd consecutive year. IBM’s 7,534 patents awarded in 2014 were the most U.S. patents ever awarded to one company in a single year.

 

While Buffett was almost certainly aware of the evolving technology landscape, IBM’s 100+ year track record of adaptation and survival, consistent cash flow generation, commitment to R&D, and entrenchment with customers was probably enough for Buffett to believe in the durability of the cash flow and brand, even if Big Blue needed to slightly change shapes over the coming years.

 

What Might Buffett Have Missed?

Since September 2011, around the time of Buffett’s initial purchase, IBM has returned -1% compared to +87% for the R1000 index.

 

While Buffett is known to relish opportunities to add to an existing position during periods of prolonged weakness or market stagnation (and IBM has been buying back stock), has he been wrong about IBM?

 

Let’s look at three factors Buffett might have missed.

 

1. Share Buybacks and (Excessive) Cost-cutting Help Near-term EPS but Create Long-term Problems

Looking first at IBM’s GAAP diluted earnings per share (“EPS”), the company has done a nice job growing earnings over the last decade. As seen below, EPS tripled from FY05 through FY13:

 

 

Operating margins steadily marched upward, reaching a peak of 20%:

 

 

But what about sales growth? With all of the EPS and profitability growth, surely revenue must have contributed some operating leverage, right?

 

Wrong. As seen below, IBM’s total sales have gone nowhere over the last decade, remaining in the low $90 billion range.

 

 

So why have earnings grown so much with almost zero revenue help?

 

Well, over the last decade, IBM has made some structural improvements to its mix to be less hardware oriented in favor of higher margin software and services. Assuming these newer opportunities can provide profitable growth, this is a good thing.

 

IBM’s strategic shift has resulted in the company shedding many of its legacy hardware operations and investing, both organically and via acquisitions, into faster-growing areas such as analytics, the cloud, business apps, and security. As mentioned earlier, hardware sales account for only 10% of IBM’s total sales today:

 

 

Mix improvement is a healthy reason for margins to improve despite stagnant total sales and could lay a foundation for long-term success. As an aside, one could look at these divestitures with a healthy a dose of skepticism – these hardware lines of business were once very profitable and competitive for IBM, but later became unprofitable and uncompetitive. Perhaps these divestitures serve as examples of a once-dominant company sitting on its laurels for too long, forgetting how to profitably innovate to maintain a strong market position.

 

Regardless, IBM’s management has made EPS growth the company’s sole focus over the last decade (read more about IBM’s heavy EPS focus here: http://www.businessinsider.com/ibm-gives-up-on-its-2015-promise-2014-10), a dangerous proposition for a technology company that should primarily be concerned with continuous innovation.

 

As we know, EPS can improve from sales growth, profitability improvements, and/or less shares and debt outstanding.

 

In IBM’s case, the EPS growth was driven significantly by share repurchases and cost cutting measures rather than strong underlying fundamental performance of its businesses.

 

From FY05 through FY14, IBM repurchased nearly 40% of its shares:

 

 

If share count had remained flat from FY05 onward, EPS in recent years would be lower by around 30%.

 

While share repurchases are a rather straightforward way to increase EPS, cost cutting can be a riskier move. With so much focus on EPS and a maturing of the mainframe market, laying off employees was an easy path to improve EPS – cost cutting began in earnest in 2010, with the latest round of job cut rumors circulating last month: http://www.businessinsider.com/ibm-watchdog-more-layoffs-this-month-2015-6.

 

There have even been rumors that managers are required to cull a certain percentage of their staff regardless of performance. Imagine trying to innovate in an environment like that.

 

Chronic layoffs have caused employee morale to drop significantly and jeopardize IBM’s ability to attract top talent going forward, which is more important than ever as the company ventures outside of the mainframe market for future growth.

 

As seen below, courtesy of Glassdoor.com (an employee review site), IBM scores the lowest of any of its competitors across CEO approval, the percentage of employees who would recommend the company to a friend, and the overall star rating:

 

 

Until IBM puts less emphasis on EPS and more on employees and innovation, the Google’s and Amazon’s of the world seem likely to take dominant positions in the new markets IBM is investing in. You can’t cut your way to success in fast-moving technology, and IBM appears to have a serious values problem rippling throughout its culture.

 

Unfortunately, IBM might need a new CEO to get there, and the majority of employees (53%) already disapprove of the current leadership. IBM’s current CEO Virginia Rometty took the helm in 2012 and either didn’t have the insight or braveries to reduce the focus on EPS and steer the company away from a “strategic” roadmap that was headed off a cliff. It could foreseeably take years, if not decades, to right the ship.

 

2. Transition to Cloud Happening Faster than Expected

IBM had plenty of attractive characteristics for Buffett to latch onto (e.g. long-term customer relationships, a chunky R&D budget, mission-critical mainframes), perhaps causing him to underestimate the rapid ascent of cloud computing and the potential impact it could have on the IT infrastructure and services industry.

 

Cloud vendors like Amazon are in the business of providing computing infrastructure like a utility so companies don’t need to maintain their own IT infrastructure. The cloud is appealing to certain businesses due to lower upfront costs (no need to purchase and manage their own mainframes and servers), greater flexibility (rent on a monthly basis), scaling, and faster time to market.

 

Hadoop allows cloud providers to rope together hundreds, or even thousands, of cheap generic servers for data processing for customers across many industries. Previously, this work would be done on expensive servers or mainframes from IBM.

 

Amazon started seriously investing in the cloud nearly 10 years ago and enjoys a first mover advantage. According to a 2014 report by Gartner, Amazon had five times more computing capacity than its competitors.

 

Amazon started reporting its cloud computing business separately, and it’s fair to say that this business has become an important and previously unexpected driver of profit growth for the company over the last 12-18 months.

 

In other words, most customers are getting their computing done cheaply in the cloud. This means less hardware business for IBM, which ultimately endangers many of its high-margin software and support products over time. According to Baird, cloud is at risk of cannibalizing IBM’s traditional business:

 

“We estimate that for every dollar spent on [Amazon Web Services], there is at least $3 to $4 not spent on traditional IT, and this ratio will likely expand further. In other words, AWS reaching $10 billion in revenues by 2016 translates into at least $30 to $40 billion lost from the traditional IT market.”

 

While IBM has a fast-growing cloud business of its own, the offering’s current competitiveness has been under question. In 2013, IBM failed to win the bid for the CIA’s cloud computing contract, worth approximately $600M. IBM even bid 30% lower than Amazon, which had no meaningful experience with government. Even still, IBM’s bid was denied on technical grounds – altogether, the government found the risk of going with IBM to be “high” compared to “low” with Amazon.

 

Additional questions were raised when IBM spent $2 billion to acquire SoftLayer in 2013. SoftLayer is basically the infrastructure for IBM’s cloud operations. IBM was unable to build its own successfully, so it shut down much of its existing cloud computing services after the deal closed. In fact, IBM has “invested” $8B to acquire 18 cloud companies.

 

With 10+ layers of management and chronic cost-cutting initiatives, it’s hard to imagine these acquired businesses thriving or coming together to form a competitive, sustainable, and trusted cloud solution. If anything, it wreaks of IBM’s desperation to follow the trend.

 

This is related to the first point above regarding IBM’s culture and innovation – the company’s current approach seems very reactionary, following the crowd (IBM’s “strategic imperatives” couldn’t be more buzz-worthy: cloud, analytics, mobile, social, and security) and buying competing products.

 

3. The Future Return Earned on “Strategic” Investments

Given the pace of industry change, IBM announced it would shift $4B of spending to its “strategic imperatives” of cloud, analytics, mobile, social, and security technologies.

 

The spending plan prompted IBM’s CEO to set a new financial target for those faster-growing segments: $40 billion in combined annual sales by 2018, or more than 40% of IBM’s total revenue (compared to less than 30% today).

 

Bulls point to the nice growth rates those areas are currently enjoying for IBM. However, what’s to say those investments will generate attractive returns going forward? IBM’s current profitability (~20% operating margins) is elevated relative to most businesses, driven by its lucrative position in mainframes and associated software.

 

What if IBM catches up to Amazon, Microsoft, Google and other cloud providers only to find that profitability has been completely eroded? Price cuts in excess of 30% are not unheard of in these markets. Business applications, security, and analytics are also much more dynamic markets than mainframes, making it more difficult to forecasting future cash flows.

 

Even if the margins are there, it could take a decade before IBM’s new businesses are generating the same level of sales and income as the legacy businesses they are intended to gradually replace.

 

Why Buffett Could Still Be Right

The bull case centers on the durability of IBM’s legacy mainframe hardware/software/services business (i.e. cloud fears are overblown; mainframes have staying power) and the ultimate success expected from IBM’s continued investments in growth markets – e.g. cloud, analytics, security, etc. – which will further enhance mix and long-term growth prospects.

 

Mainframe Business is Steadier and More Cloud-resistant than Expected

Should IBM’s business and revenue continue to fade, it seems more likely to be a gradual decay than a rapid drop off. As mentioned earlier, hardware is only 10% of IBM’s sales, but mainframe-related software and services account for 30% of profits.

 

While cloud computing is hurting some demand for mainframes, they remain very important for many customers. According to Gartner, 92 out of the 10 largest banks in the world use IBM’s z System mainframes. Today, roughly 80% of corporate data is still managed by mainframes! Gartner also noted that IBM has over 1,300 software company partners developing products for its mainframe, reinforcing the strength and importance of the platform.

 

With mainframes being built specifically for mission-critical applications that require 100% reliability and security, many large customers in risk-averse industries like banking and insurance are unlikely to switch away anytime soon, if ever. It should also be noted that mainframes can be used for private or hybrid cloud computing and mobile computing, embracing technology advances to stay relevant.

 

From a cost perspective, mainframes do have a much higher up-front cost than servers, but given the right workload they can actually deliver a lower total cost of ownership compared to using a sprawling server farm. In some ways, all the big cloud providers are really doing is trying to recreate the mainframe by hashing together a lot of servers.

 

Finally, many mainframe customers face high switching costs to migrate somewhere else. With many business-critical applications running on a mainframe and potentially decades of old programming code and logic built into it, a substantial investment of time and money would need to be made. Simply put, many large companies will not move all of their business processes to the public cloud.

 

The release of IBM’s new generation mainframe, the z13, occurred in January 2015. IBM spent five years developing this mainframe, which could stabilize hardware and related sales.

 

Strategic Areas Showing Strong Growth

In 2014, revenue from cloud, analytics, mobile, social, and security solutions grew 16% with double-digit growth in each quarter. In total, these strategic areas accounted for $25 billion in sales, representing 27% of IBM’s total revenue.

 

Additionally, IBM established partnerships with Apple (business apps and cloud services), SAP (will run its business applications on IBM’s cloud), Twitter (incorporate Twitter’s massive data streams into IBM’s cloud-based analytics, customer engagement platforms and consulting services), and Tencent (public cloud infrastructure) in each of these areas in 2014, adding some credibility to its position in enterprise computing.

 

Furthermore, IBM has a good foundation to start from – significant scale, extensive relationships with big corporate clients, and a large R&D budget.

 

Watson is another exciting opportunity that investors could be overlooking. IBM has invested more than $26 billion, including over $17 billion on more than 30 acquisitions, to build its capabilities in big data and analytics.

 

In 2014, IBM reported nearly $17 billion in business analytics revenue, and the company established the Watson Group to develop and commercialize cognitive computing innovations. The company has committed a $1 billion investment to Watson and is also making Watson more widely available through the Watson Ecosystem. IBM also launched Watson Analytics, a breakthrough natural language-based cognitive service that provides instant access to powerful predictive and visual analytic tools for businesses.

 

Conclusion

IBM’s past four years have not likely played out exactly how Buffett originally envisioned. Or, if they have, Buffett was clearly years ahead of the market with his expectations for weak growth and a drawn out transformation.

 

Many of IBM’s problems run deeper than reported numbers, starting with a culture that seems to be losing its edge in innovation and values thanks to an extreme focus on cost-cutting and meeting superficial EPS targets.

 

The company certainly has the financial firepower, customer relationships, and brains to adapt, but it is currently behind in the race and will require a shift in mindset regarding its legacy cash cows, which seem likely to continue fading slowly. With an employee base in excess of 400,000 people, righting the ship will likely take years, not quarters.

 

Time will tell if IBM’s fast-growing but largely unproven strategic initiatives will be able to more than offset the slowing down of older cash cow businesses. Valuation looks undemanding, but the risk of IBM continuing to tread water or require yet another leadership and strategy change keep us on the sidelines for now.

 

For dividend investors seeking current yield, IBM’s 3.3% dividend yield is safe, and 25+ years of dividend data can be seen here. However, sustainable growth could remain challenged going forward.

 

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