IBM: Can Elephants Still Dance?

Overview

IBM is a 100+ year old business with a market cap of over $150B. It has 400K+ employees, and has operations in most countries of the world. It operates in the technology sector, where its age and size might very well earn it the moniker of “dinosaur”.

The key question is this: is IBM a dinosaur like T. Rex just before that fateful big rock hit the earth? Or is it like the dinosaurs that survived by transforming themselves to birds?

In 2015, IBM did about $82B in total revenue. The split among its divisions was as follows:

  • Global Business Services (21%, 13%)
  • Cognitive Solutions (22%, 37%)
  • Technology Services and Cloud Platforms (43%, 29%)
  • Systems and Financing (14%, 21%)

The first and second numbers in the parenthesis represents the percentage of revenue, and pre-tax income, respectively.

For 2015, IBM had a pre-tax income (PTI) of 15.9B and a net-income of $13.2B.

Backstory

Over 2006-2012, revenue and PTI increased from about $90B and $13B, to $105B and $21B, respectively. Since 2012/2013, the tune has become more sullen. Revenues have fallen to $82B, and PTI has dropped to $15.9B in FY 2015.

IBM is trying to shed “empty calories” by divesting businesses with poor profit margins, and trying to re-adapt to a changing world by focusing on higher-margin “strategic imperatives”. This can be seen in a general increase of PTI margins from 14.5% in 2006 to around 20% in the past few years.

While investments in these new areas are starting to produce some green shoots, they haven’t been able to offset the decline in revenues and income caused by divestiture of legacy businesses. EPS peaked in 2013 at over $15, but has dropped since then to $13.50 in 2015, with a similar number expected for FY 2016.

Currently the strategic imperatives bring in about 40% of the revenue, and are growing at a healthy 10%/year clip, while the remaining part of IBM is shrinking. It is unclear what the IBM that emerges from this transformation will look like.

The task before IBM’s management reminds me of trying to start a stick-shift car on a hill. You need to manage your (non-clutch) foot skillfully between the accelerator and the brake. If you don’t give enough gas, the car rolls back, and makes you uncomfortable. Your instinct is to slam on the brakes to check the slide, but in doing so, you risk not making progress, or worse, stalling.

Sources

Since Warren Buffett’s purchase, IBM has become a staple on value investing blogs/forums. Here are links to some excellent discussions:

There are lots of good reasons to be for, or against, IBM.

Analysis

To avoid spilling more unnecessary ink, I am going to try to format my thoughts in terms of a Q&A.

Q: Are you long or short IBM?

I am long with an average price of $155/share. I bought most of my shares, after IBM reneged on their 2015 $20 EPS guidance.

Q: Did you try to clone Buffett?

Mostly, yes!

IBM is a very complicated business, with lots of moving parts. When Buffett talked about the stickiness and annuity-like nature of the business, my natural thought was this guy (i) probably has the best nose for moats, (ii) has read 50 years worth of 10-Ks, and (iii) stuck in a fair chunk of BRK cash into IBM. I looked at its history, and saw an extremely profitable enterprise with amazing margins. At a P/E of 10x-12x, IBM also seemed cheap enough.

My biggest worries about IBM (durability, financial engineering, complexity) were definitely assuaged by Buffett’s buy.

Q: What about all this financial engineering?

One man’s financial engineering is another man’s capital allocation. Not many people complain about John Malone’s financial engineering at Liberty, although his moves sometimes seem magical/opaque. He gets a pass, deservedly, because we trust his capital allocation skills.

That said, the aforementioned 2015 target of $20 EPS did incentivize sub-optimal allocation, by channeling more FCF towards buybacks than towards growth reinvestment.

I am glad to see those shackles go.

Q: IBM doesn’t spend enough on R&D.

IBM spends enough (almost 6% of revenues) on R&D. It also files a lot of patents. How commercially valuable they are, I haven’t the slightest clue.

One of these days, I am going to recalculate its ROIC by capitalizing R&D.

Q: Revenues are declining precipitously. Doesn’t that bother you?

A large part of the revenue decline has been willingly brought on. You could almost say, it has been engineered. IBM is trying to shed excess fat, and gain muscle. This involves going on a diet and exercising. The process can be painful: sometimes you lose a lot of weight, without gaining enough muscle to compensate.

Q: What about all that debt?

The total company debt is nearly $40B.

About $27B is debt held by the Global Financing unit. This unit helps IBM’s customers buy IBM products by paying in installments. IBM is able to borrow money cheaply, and lend it out to these customers at higher rates. Global Financing is a small profit center in its own right. The risk of default is quite small given the quality of the borrowers.

The remaining non-Global Financing debt can be covered by about 1 year’s worth of FCF. IBM’s debt does not pose a threat.

Q: Isn’t AWS going to kill IBM?

Amazon is one of the greatest companies of our times.

However, as Buffett said in a CNBC interview “the cloud is not a winner-take-all business.” In fact, IBM’s strategy of ceding the commoditizable public cloud space to Amazon is not such a bad idea. Amazon cares about market share; not so much about profit margins. IBM is almost the mirror opposite.

In an oversimplified way, this is parallel to the iOS and Android wars. IBM, like iOS, wants to play the cloud game on different terms.

Q: Weren’t all those buybacks mistimed?

With the benefit of hindsight, it sure would have retired many more shares at $120 a pop than at $200. But if management thought that the stock was worth $225, when shares traded at $200, then I would be less hasty to label the buybacks as a misjudgment. Of course, IBM should have looked at other more profitable ways to deploy FCF before it resorted to buybacks, and the 2015 roadmap might have caused some misaligned incentives.

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