International Business Machines Corporation (NYSE: IBM) is one of the world’s largest IT companies. The company has successfully survived several major industry changes. IBM has shifted from mainframes to personal computers, to software services, consulting and outsourcing, and now cloud computing. However, the company’s share prices have fallen recently amid declining revenues as IBM takes key growth initiatives.
More importantly, world’s most respected investor Warren Buffett has accumulated a 5.4 percent stake in IBM by investing more than $10 billion. Buffett has avoided tech stocks for decades. But he couldn’t resist when he came across a compelling tech stock like IBM. Buffett believes IBM is significantly undervalued.
Let’s look at the things that prompted Warren Buffett to break his rule of “avoid tech stocks” and take a $10 billion position in IBM Corp.
About 20 years ago, IBM was on the brink of bankruptcy. But the efficient management of Lou Gerstner and Sam Palmisano rescued the company and transformed it into an IT giant. Since then, the company has shifted its focus from a low-margin hardware business to IT services. That strategic decision helped IBM increase its earnings by more than 50 percent since 2007.
In his 2011 letter to shareholders, Warren Buffett praised IBM’s extraordinary operational achievements. He added that the company has equally well financial management capabilities. The better financial management has helped the company boost shareholder value.
IBM creates a road maps, sets future targets, and evaluates its current progress. In 2007, the company created its 2010 road map, in which IBM said that it aims to reach EPS of $10–$11 by 2010. Despite the financial crisis, the company surpassed that goal, earning $11.52 per share in 2010. That impressed Warren Buffett.
In 2010, IBM unveiled its 2015 road map. Under the plan, the company aims to spend $50 billion on share buy-backs and distribute $20 billion in dividends. The company also aims to increase its EPS to $20 by 2015, and generate $100 billion in free cash flow. In its 2015 road map, IBM has stated to spend at least $20 billion on acquisitions, and increase revenues of its cloud computing division from $3 billion to $7 billion.
The company is on its way to achieve a $50 billion share repurchase target. IBM reported $15.25 per share in earnings last year. The company recently raised its EPS guidance for the current year to $16.90 a share. To achieve the $20 non-GAAP EPS, IBM will have to increase its earnings by 8.76% CAGR, which is quite realistic.
Moat or competitive advantage is one of the most important things Buffett looks for in a stock. So, what competitive advantage does IBM has over other companies operating in the same niche? IBM is now an IT consulting and services firm. Buffett considers that a wide moat. He says clients are reluctant to change their IT providers. As more and more companies start building their IT departments, they would prefer a trustworthy and iconic brand like IBM.
IBM’s track record of dividends and share buybacks speaks for itself. Since 2000, the company has spent about $26 billion on dividends and another $124 billion on share buy-backs, lowering the number of outstanding shares by 36%. Under its 2015 road map, the company plans to spend $50 billion on share repurchases.
IBM repurchases a large amount of its own shares when they are depressed. At the end of the second quarter this year, the company has 1.1 billion outstanding shares, down from 1.72 billion in 2003. That means the company has retired 620 million shares over the past decade, which is pretty impressive.
Solid Financial Position
|Revenue in millions||$98,786||$103,630||$95,758||$99,870||$106,916||$104,507|
|Dividend per shares||$1.50||$1.90||$2.15||$2.50||$2.90||$3.30|
|Shares outstanding in millions||1,385.2||1,339||1,305||1,228||1,163.2||1,117.4|
|Net profit margin||10.5%||11.9%||14.0%||14.9%||14.8%||15.9%|
|Return on equity||36.6%||91.6%||59%||64%||78.4%||88%|
IBM shares have lagged over the past few months after the company’s second quarter revenues missed Wall Street estimates. IBM posted $24.9 billion in sales for the quarter ending June 30, well below the consensus estimate of $25.4 billion. The company took $1 billion workforce rebalancing charge, the benefits of which will reflect in the coming quarters. IBM is reducing its headcount by 7,000 this year to stay competitive and cost-efficient in a tough economy.
Despite slow revenue growth in a challenging IT environment, the company’s earnings have more than doubled over the past five years. Its profit margin topped 15.9% (17% excluding workforce rebalancing charges), up from 10.5% in 2007. Warren Buffett was particularly impressed by the company’s return on equity, which increased from 59% in 2009 to 88% in 2012.
Warren Buffett started buying IBM stock in 2011 at around $159. He continued to accumulate the company’s shares until the third quarter of 2012, when the stock hovered between $185 and $197. You might very well know that Buffett believes in buying a wonderful stock at a fair price, instead of a fair stock at a wonderful price. IBM has a P/E ratio of 13.66.
Based on the company’s 2015 EPS target of $20, we get a valuation of $273.2. Warren Buffett buys a stock only when it is trading at least 25% below its actual value. That justifies almost everything. The stock is still trading at around $192. It has a P/S ratio of 2 and P/B ratio of 10.2.
Buffett buys a stock and holds it for at least 10 years. All the indicators show that IBM is still undervalued, and should be an obvious choice of a long-term investor.
What are your thoughts on IBM going forward?
Vikas is a professional financial journalist and value investor with more than four years of investing experience. Vikas spends most of his time reading investment books, writing about finance and looking for stocks that have significant growth potential.