Early this year, as a part of value investing coursework, I wrote about my understanding of IBM’s business which can be found here. Few interesting things happened after that and I wanted to discuss about it in this post. From the chart given below, you can clearly see that the stock went below the price paid by Buffett and Watsa. Why is that? The simple answer is that the stock does not know nor care about who the buyer is.
1. On Missing $20 Operating EPS
Until Q3 of this year, IBM’s management was very confident of meeting the operating EPS target of $20 by 2015. But in Q3 the management thought otherwise. Also IBM’s revenue went down across all the business segments. These two factors triggered a massive sell off. Given below are the excerpts from 2014 quarterly reports. The management should have seen this coming long back. But they ignored the disconfirming evidence because of two psychological biases commitment-and-consistency and incentive caused bias. This is the reason why Buffett never gives any earnings guidance to Wall Street. As long as the IBM’s core franchise is intact this miss doesn’t bother me. But how do I know if it’s core franchise is intact?
This delivers long-term value and performance to all key stakeholders. The execution of the company’s strategy results in the 2015 road map — with the expectation of at least $20 of operating (non-GAAP) earnings per share in 2015. – IBM’s Q1 2014
This delivers long-term value and performance to all key stakeholders. The execution of the company’s strategy results in the 2015 road map — with the expectation of at least $20 of operating (non-GAAP) earnings per share in 2015. – IBM’s Q2 2014
Given the company’s third quarter performance, the actions it is taking and with only 15 months to the end of 2015, the company no longer expects to deliver $20 of operating (non GAAP) earnings per share in 2015. – IBM’s Q3 2014
2. On Increasing Debt
From the table given below you can clearly see that IBM’s financial obligations (debt) almost doubled and its equity went down by 37%. Also its revenue is going down. Is IBM going to be bankrupt?
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IBM is not going to be bankrupt and it is financially very stable. From the table given below you can see that IBM generated $108 billion from operations in the last 5 years and 9 months. After capital expenditure and acquisitions it generated $70.8 billion as free cash flow. But it returned $97.7 billion in the form of dividends and share buybacks. This generated a deficit of $26.8 billion which was funded by taking debt and reducing its equity. But IBM bought back a lot of shares when its market price was quoting between $175 to $200. But the stock is currently quoting at $155.38. Did IBM squander money in share buybacks? Hold onto your thoughts for some more time and I will address it in the valuation section.
[Click the image to view it clearly]IBM has a total debt of $45,467 million. Of which $28,404 is a finance debt and the remaining $17,293 is in-house debt. What is a finance debt? IBM lends money to its customers for buying IBM’s products and services. For lending money IBM charges interest. Since IBM has a very good credit rating it can borrow money at a low rate and lend it to its customers at a higher rate. The division that does this is called as global financing and it’s highly profitable.
Around 62% of the total debt is finance debt and it will be paid back by its customers. How do I know the credit worthiness of IBM’s customers. What if they go bankrupt? Majority of its customers have credit ratings given by Standard & Poor’s and this is published in IBM’s annual reports. As of 30th Sep 2014 around 62% of IBM’s customers have been rated as investment grade ranging from AAA to BBB- and this ratio is stable compared to 31st Dec 2013. Also in the next three years IBM should payback long term debt worth of $16,629 million. This should not be a problem even if all the non investment grade customers default as IBM’s cash flows are highly predictable. So IBM’s debt is not an issue.
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3. On Declining Sales
In the table given below, I broke down IBM’s key business segments revenue, gross profit, and pre-tax income and normalized it by keeping 2009 as the base year. Profits for services and software segments grew faster than its revenue. When will this happen? This happens when the company is getting out of low margin business with little or no differentiation by divestitures and getting into high margin businesses with a very strong differentiation through acquisitions. IBM has been doing this for the last two decades and these actions should not surprise anyone.
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Given below are the divestures and acquisitions IBM has been doing in the last few years. The sale of microelectronics, x86, and customer care business resulted in lost revenues of $7 billion in 2014. But these businesses were generating a loss of $500 million. Overall it is like getting rid of empty calories. IBM’s acquisitions are done in the areas of Cloud, Big data, Mobile, Social, and Security. They help IBM to provide high value services to its clients and to differentiate itself from its competitors. You can find the complete list of acquisitions here.
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These divestitures explains some but not all the decline in revenues. There are other challenges that IBM is facing which are summarized below.
(1) Systems and Technology (STG): This is IBM’s hardware division selling high end mainframe servers. If you look at the trend analysis you will find that its revenue went down significantly compared to 2009, a low base year due to recession, and this segment started losing money since 2013. This trend is continuing in the year 2014 also. One of the reasons is due to its key mainframe server called as System Z. From the table given below you can see that whenever a new version of the server gets released the revenue goes up compared to the previous year and it declines afterwards. Taking this at the face value this does not appear to be a huge problem. But we need to watch this trend carefully.
Systems and Technology (STG) revenue decreased 15.0 percent (15 percent adjusted for currency) and 16.0 percent (16 percent adjusted for currency) in the third quarter and first nine months of 2014, respectively, versus the same periods in 2013. This performance reflects year to year declines related to the product cycle of System z as well as declines in Power, Storage and System x. Although both Power and Storage declined compared to the prior year, both brands improved sequentially compared to the second quarter of 2014. – IBM’s Q3 2014
Apart from System Z all other products in STG had sales execution issues which is clearly indicated by declining year-over-year sales. The company sold its Microelectronics and System X businesses to GLOBALFOUNDRIES and Lenovo. To me this is a positive development as they are low margin and capital intensive businesses. The company is repositioning its Power Systems and claims that its strategy is working as indicated by lower decline in sales. But we need to wait and see how this is playing out. Also the company sees that the value in the storage business is shifting towards software, and in the third quarter of 2014, storage software revenue grew. Overall STG is the root cause of declining sales and we need to wait and see if the actions taken by the company is producing any positive changes.
(2) Software: IBM’s software business segment is highly profitable and it generates around 50% of its pre-tax income. Its main strength comes from its middleware offering which generates around 80% of software revenue. This division was growing at low single digits. But in Q3 its revenue was flat. Also some of its key branded middleware components had declining year-over-year sales which is given below. The management told that they had some sales execution issues. Not sure how to interpret it. But we need to watch this trend carefully.
(3) Services: Until 2012 its services division was growing at low single digits. But from 2013 onwards its sales started declining little bit. Take for instance its application outsourcing which decreased 7.5% in 2014. Why would this happen? This happens when the offerings are less differentiated and the company is losing out to its competition on pricing or it needs to reduce the price to get the contract.
GBS also continued to benefit from the previous workforce rebalancing actions, but this was more than offset by other factors which included the impact of lower revenue on a relatively fixed cost base. In areas where the company has strong differentiation, such as solutions that address the strategic imperatives, there is good growth and gross margin performance. However, in the parts of the portfolio that are not as well differentiated, there is continued price and profit pressure. In these areas, the company will be more aggressive on the use of global delivery centers and in applying intellectual property for faster time to value for its clients and improved business results for the company. – IBM’s Q3 2014
From all this we can clearly see that IBM is facing headwinds in all the business segments. But let us not miss the forest (broad trends in the industry) for trees (quarter to quarter changes). The IT industry as a whole is seeing an unprecedented change as customers wants to (1) manage their IT and software on cloud (2) need to analyze huge volumes of data to make decisions (3) engage their workforce through social and mobile offerings (4) keep everything secure. Is IBM investing heavily on these items? I believe it does does and the management calls them as strategic imperatives and it is doing very well.
The company has a set of offerings that address the strategic areas of data, cloud and the way clients are engaging. Revenue in the strategic imperatives was up double digits in the first nine months of 2014 with approximately half of the content in software. Business analytics revenue increased 8 percent with the strongest growth coming from GBS. This is a large business for the company with revenues in 2013 of nearly $16 billion. The company has a broad analytics portfolio that helps clients to extract value from their data. Cloud revenue was up over 50 percent year to year. The delivered as-a-service component was up over 80 percent and exited the third quarter with an annual run rate of $3.1 billion. The company’s cloud portfolio supports the full scope of enterprise client cloud requirements, including solutions for private, hybrid and public clouds. In engagement, mobile revenue more than doubled year to year, social offerings returned to growth, with double digit growth in the third quarter, and security revenue was up over 20 percent. This was the 8th consecutive quarter of double digit growth in security. – IBM’s Q3 2014
4. On Valuation
I will be using Penman’s residual earnings method to value IBM. If you want to learn about residual earnings go here. On Sep 30th 2014 IBM had $60,087 million in net operating assets. In 2013 its services division earned $10,197 million pretax and its software division earned $11,106 million pre tax. Adding this we get $21,303 million pretax. Applying an effective tax rate of 25% IBMs after tax earnings comes to $15,977 million. Let us assume that its STG and its financing division will not make a dime. Also I am assuming that IBM will not grow at all. These assumptions are very conservative.
Step 1: I need a solid anchor to base my valuation on. Let us start with its net operating assets which comes to $60,087 million. IBM earned 26.6% after tax on its net operating assets. I arrived at this by dividing $15,977 million by $60,087 million.
Step 2: Everything in life has an opportunity cost. Let us assume that the after tax opportunity cost I am expecting is 7%. In US this is really hard to get as the asset needs to earn 9.33% pretax. After applying the opportunity cost of 7% on $60,087 million we get $4,206 million. Subtracting this from $15,977 million we get the residual earnings as $11,771 million.
Step 3: How much capital do I need to earn $11,771 million. At 7% opportunity cost I need to put $168,157 million ($11,771 million/ 0.07)
Step 4: Adding the value arrived at Step 1 and 3 we get $228,244 million ($60,087 + $168,157). From this subtract IBM’s in-house debt of $17,293 we get $210,951. On Sep 30th 2014 IBM had 989 million common shares outstanding. From this we can get the intrinsic value per share of IBM as $213 ($210,951 / 989). As of this writing IBM’s quoted price is $155.38. At this price you are buying $1 for 0.73 cents. We arrived at this valuation by assuming that IBM will not grow and ignored its efforts on Watson and double digit growth the company is seeing on its strategic imperatives.
Now let us come to my earlier question on share buybacks. What is wrong in share buybacks when you are getting a dollar for 0.73 cents by taking debt at 4%. Why do so many investors cringe about this? They think that price and value are the same. But they are not as price is what you pay and value is what you get. Take a look at what Buffett wrote about buybacks in 2011.
Charlie and I favor repurchases when two conditions are met: first, a company has ample funds to take care of the operational and liquidity needs of its business; second, its stock is selling at a material discount to the company’s intrinsic business value, conservatively calculated.
5. Who is right?
Investing is not a game against nature, but against other investors. On one side Mr.Market is selling IBM as it thinks that the company will not adopt to the shift towards cloud. On the other side Buffett and Watsa are buying IBM by thinking that the company will adopt to this shift due to its deep relationships with its customers. Who is right? No one knows for sure as we don’t know how the future will unfold. At the same time the odds of IBM’s success is not 50-50. A guy like Buffett never places a blind bet. He thinks probabilistically by using mental models and bets heavily when the odds are strongly in his favor. Take a look at what Charlie Munger told about IBM.
You could see how entrenched IBM was in many places, including the Burlington railroad. I think our business experience helps our investment judgment, and vice-versa. … We’ve always said that what we like best was owning a wonderful business outright, and second best we like good ideas in securities. That has never changed – Charlie Munger, CNBC 2012
Most big software companies hate dealing with the government. IBM got very good at it, but everybody else just hates it. – Charlie Munger, DJCO 2014
IBMs mainframe systems stores several decades worth of customer’s business data. Several hundreds of software programs accesses, analyzes, and presents this data in a usable form. These systems are scalable, available, and secure. The entire business operations adopts to these mainframe systems. If something is running for that long it is not easy to migrate to another system without taking substantial risk. This is what Munger meant when he used the word entrenched. For a customer to move to another system the switching costs are very high. This is a huge moat. I have been developing applications software for 14+ years and I know how hard it is to migrate from Oracle to another database. IBM’s mainframes are much more deeper and harder to migrate compared to Oracle.
So, if a company wanted to change from an Oracle database to one sold by a competitor, not only would it need to move all the data seamlessly from the old database to the new one, but it would also have to reattach all the different programs that pull data from Oracle. That’s a time-consuming and expensive proposition, not to mention a risky one—the conversion might not work, which might result in a big business disruption. A competing database would have to be phenomenally better (or cheaper) than an Oracle database for a company to choose to pay the massive cost of ripping out its Oracle database and installing another one. – The Little Book That Builds Wealth
Who are IBM’s main customers? Given below is the global financing portfolio of IBM and you can see that more than 50% of its customers are from finance and government sectors. Buffett major holdings Wells Fargo and BNSF are IBM’s customers. The main business for these customers is not technology and they don’t care about cutting edge but instead care about its functioning. Let us assume that there is a bold customer who is going to switch away from IBM. What are his incentives in doing that? Nothing much, he might get a bonus. But what about his downsides? He might lose his job if the decision backfires. So he will maintain his status-quo. As Buffett tells – Failing conventionally is the route to go; as a group, lemmings may have a rotten image, but no individual lemming has ever received bad press.
At December 31, 2013, the industries which made up Global Financing’s receivables portfolio consisted of: Financial (39 percent), Government (14 percent), Manufacturing (14 percent), Services (8 percent), Retail (8 percent), Healthcare (6 percent), Communications (6 percent) and Other (4 percent). – IBM’s 2013 Annual Report
No one knows for sure how the future will unfold for IBM. But I believe that given IBM’s deep customer relationships the odds looks favorable for Buffett and Watsa. As of this writing I do not own any shares of IBM.