Capitalism is creative destruction. This statement is very true for the information technology (IT) industry. In order to thrive in this industry, companies should constantly innovate and adapt to the ever changing conditions. Take a look at the evolution of the IT industry. International Business Machines (IBM) is the only company which thrived for over 100 years.
IBM was founded in the year 1911. It is headquartered in Armonk, New York. In 2012 the company had around 430,000 employees and operated in 170 countries. Many businesses invent and commercialize technology. Others are experienced in helping clients transform their enterprises for competitive advantage. IBM does both. It sells services, software, and hardware to enterprise clients. It uses IT to solve clients business problems. Its operations consists of five business segments. They are (1) Global Technology Services (2) Global Business Services (3) Software (4) Systems and Technology Group (5) Global Financing.
1. Global Services
Global Technology Services (GTS) and Global Business Services (GBS) is collectively called as Global Services. It is the key component which provides IT infrastructure and solutions to clients. What does this mean? In the book Who Says Elephants Can’t Dance – Louis Gerstner does a fantastic job of explaining the services business.
In services you don’t make a product and then sell it. You sell a capability. You sell knowledge. You create it at the same time you deliver it. The business model is different. The economics are entirely different. Think for a moment about just the outsourcing business. What you’re telling the customer is: “Transfer your IT assets – products, facilities, plus the staff – onto my books. I’ll absorb it all, manage it, guarantee performance levels, and promise that you’ll always be on or close to the leading edge of technology. All that, and I’ll charge you less than it’s costing you now.” At the same time, you’re telling yourself: “I can do all that and still make a profit.“
In 2013 around 57% of IBMs total revenue came from global services. 60% of services revenue is annuity based. In annuity, the client signs a multi year contract with IBM. During that period IBM provides IT services and in exchange client pays fixed sum of money every year. There are several benefits in the annuity business (1) It provides a solid base of business in good and bad times (2) It reflects deep customer relationships (3) A good source of profit and cash. At the end of every year IBM publishes the total value of its backlog. Backlog is the dollar value of unshipped orders available for delivery in the next year, ultimately resulting in net sales. Backlog gives a good indicator of what might happen in the next year. Revenue generated from the backlog is approximately 70% of total services annual revenue in any year. Annuity and Backlog provides stability to the IBMs business. This is one of the reasons why Warren invested $10 billion in IBM.
In order to solve clients business problems using IT you need software. IBM makes middleware and operating systems software. Following are its key software capabilities (1) WebSphere (2) Information Management (3) Tivoli (4) Lotus (5) Rational (6) Operating Systems. In 2013 software contributed to 26% of IBM revenues and 2/3rd of this revenue is annuity based coming from recurring license charges and ongoing post-contract support. The remaining 1/3rd comes from one-time charge (OTC) in which clients pay one, up-front payment for a perpetual license. Software is IBMs cash cow. In 2013 it had a gross margin of 88.8% and 50% of its total pre-tax income came from software alone.
3. Systems and Technology Group
In order to solve clients business problems using IT you need hardware. Systems and Technology (STG) is commonly identified as the hardware or mainframe division. It provides clients with business solutions requiring advanced computing power and storage capabilities. Following are the STG components (1) Systems (2) Storage (3) Microelectronics. In 2013 STG contributed to 14.4% of IBM revenues. It had a pre tax loss of $507 million.
4. Global Financing
Clients need money to pay for IBM services. Sometimes they might not have all the money. Global Financing division lends money to clients so that clients can acquire IBM systems, software, and services. In return it charges interest on the loan. In 2013 around 2% of the total revenue came from this division. IBM funds these loans by using debt. In 2013 its global financing debt alone is $27.5 billion which represents 70% of its total debt of $39.7 billion.
Is this a good business?
In the last six years, IBM invested capital averaged around $75 billion. On that capital it had an average operating income of $20 billion which translates to around 27% return and an average free cash flow of around $16 billion which translates to around 22% return. These are good returns and hence it is a good business.
|Invested Capital (IC)||$69,705||$68,632||$71,992||$73,242||$77,619||$83,522||$74,119|
|Operating Income (OI)||$18,812||$20,773||$19,549||$19,846||$22,492||$18,789||$20,044|
|Free cash flow (FCF)||$14,641||$17,326||$15,565||$15,787||$18,185||$15,021||$16,088|
|OI / IC||26.99%||30.27%||27.15%||27.10%||28.98%||22.50%||27.04%|
|FCF / IC||21.00%||25.24%||21.62%||21.55%||23.43%||17.98%||21.71%|
As a shareholder we cannot control what a management does with its cash. Hence it is very important for us to see what they did with the cash. In the last 6 years IBM generated free cash flow of around $96.5 billion. It returned around $20 billion to shareholders as dividends. It bought back its own shares for around $75 billion. IBMs management returned around 98% of the free cash flow back to the shareholders. This is unheard of in the IT industry. Hence IBM management is shareholder friendly. In 6 years it reduced its outstanding shares by 20.5%. This is one of the reasons why Buffett invested over $10 billion in IBM. If you need to understand why share buybacks are important read Buffett 2011 shareholder’s letter.
|Free cash flow||$14,641||$17,326||$15,565||$15,787||$18,185||$15,021||$96,525|
IBM Shares Outstanding:
If it returned all the money to shareholders does it not innovate? In the IT industry companies that does not innovate will perish. In the last 6 years IBM spent around $6.1 billion on average in R & D. It acquired several companies and paid around $22 billion in total. Most of its acquisitions are in the business analytics, cloud computing, and security space. Since most of the cash flow is returned to the shareholders it used debt and sold some of its low margin businesses to fund these acquisitions. From this we can clearly see that IBM is innovating and the management is handling its finance wisely.
|R & D||$5,820||$6,337||$6,026||$6,258||$6,302||$6,226|
In 2010 IBMs management came out with a roadmap which clearly laid out what they are going to achieve by 2015. It wants (1) Software to become about half of segment profit (2) Growth markets approach 30 percent of geographic revenue (3) Generate $8 billion in productivity through enterprise transformation (4) Return $70 billion to shareholders. $50 billion through gross share repurchases and $20 billion in dividends. (5) Invest $20 billion in acquisitions. By doing all this the management wants $20 as its operating EPS. By the end of 2013 operating EPS is at $16.28 and the management believes that they will hit $20 in 2015. Clearly the management is transparent with its shareholders.
There is a famous saying – Nobody ever got fired for buying IBM equipment. IBM is present in 170 countries and with a revenue of $100 billion. In the consulting and systems integration space IBM is the number one global provider and it is 38% bigger than the next competitor, Accenture. In the IT outsourcing space, IBM is also the number one global provider – 78% larger than the next competitor, Hewlett Packard. Also IBM spends $6 billion in R & D. IBM has reputation, track record, client relationships, scale advantages, and creates switching costs for its clients and they all give it a big moat. Let us do a porters five force analysis on IBM.
Threat of New Entrants – It is easy for any company to enter into the IT industry. But it takes a lot of time to win the trust of customers. IT is one of the key assets of every organization and hence customers are not going to hand their IT department over to a new entrant without a track record. Also to reach the scale of IBM for a new entrant is not an easy task. Hence the threat from new entrants is low.
Bargaining power of suppliers – IBM sells knowledge. Its key suppliers are its employees and their bargaining power is low.
Bargaining power of buyers – Enterprise clients are its buyers. Most of the clients IT budgets are non-discretionary and they are annuity based. Also a deep domain knowledge about the clients business is needed to solve their problems. IBM also uses its software for providing solutions. All of these are sticky in nature and it ensures that once IBM lands a customer, that customer is likely to remain a loyal client for many years to come. Hence the bargaining power of buyer is low.
Threat of substitutes – I do not see any substitutes for IT. But the mode of delivery is changing and moving towards cloud. IBM is making big bets in cloud and in 2013 it acquired SoftLayer for $2 billion to strengthen its position in public cloud. Since it is competing with a well established giant like Amazon I am putting the threat of substitutes as medium.
Rivalry among existing competitors – IBM competes with several other companies in each of its segments. Its competitors include Amazon, Oracle, HP, and Accenture. They are big and able companies and can take away IBMs market share. Hence the rivalry from competitors is high.
In the last six quarters IBM had a declining revenue. In spite of declining revenue it was able to increase its net income per share by (1) Margin expansion (2) Share buybacks (3) Favorable tax rates. It cannot continue doing this forever without increasing the revenue. The major reason for the declining sales is because of its hardware division. In 2013 this segments revenue fell by 18.7%. China is a major hardware market for IBM and it supplies hardware to major state owned enterprises. Currently China is undergoing a broad economic reform and this is one the reasons why the sales dropped. There are few issues with the hardware business model and the company is trying to fix it. For now this division is clearly dragging its sales and profits.
IBM has four growth initiatives and let us see how they performed in 2013 (1) Business Analytics revenue went up 9 percent (2) Smarter Planet revenue up approximately 20 percent (3) Cloud revenue of $4.4 billion, up 69 percent (4) Revenues from the company’s growth markets decreased 9 percent and China is a major contributor for this. Hence most of its growth story is intact.
In a technology conference with Credit Suisse, Dr. John E. Kelly III, IBM SVP & Director of Research discusses about (1) Business Analytics (2) Cloud Computing and why Amazon is not a threat to IBM (3) Watson (4) Why mainframes will stay for a long time. I strongly recommend listening to the speech.
In 2013 IBMs free cash flow per share is $13.62. As of this writing the share is trading at $182.79. Hence the free cash flow yield comes to around 7.5%. This is a decent yield in the current environment. Hence the stock appears to be trading at reasonable valuations. Let us look at it another way. I used reverse DCF to find out how much growth is expected out of IBM stock at the current price. The market expects IBM to grow its free cash flow at 3.5% for the next 10 years and 1% thereafter.
The growth rate market expects to justify the current stock price is much lower than Gartner estimate of 5% growth in the overall IT industry. On top of that IBMs analytics, cloud, and smarter planet are growing revenue at double digits. IBM Watson the cognitive computing engine might become a positive black swan which is ignored by the market. I believe the stock is undervalued. I currently do not own shares of IBM and I might start to buy if it comes closer to $172 the average price which Buffett paid.