IBM - International Business Machines

[TheAiGuy]

Okay, so I read over the thread and I've been thinking about this one for months and IBM's a "no" for me at today's prices.

 

1) I don't understand how IBM earns supra-normal returns on capital on a prospective basis. Buffet has claimed that IBM has "infinite" returns on tangible assets but this is a terrible argument as IBM has to constantly invest via R&D and M&A.

 

2) I don't get where anything but slow growth comes from. Sure, Cloud, Analytics, et al will grow, but much of this growth is offset by earnings declines elsewhere. It's not clear how big the new markets are or how much value IBM is loosing from the old ones. My guess is that the new markets are pretty big and valuable, but its not something that IBM is uniquely advantaged in. There are competitors on the consulting side (e.g. Palentir, Square, Zenefits, etc) and new firms that are more able to focus their business to leverage analytics (Uber, retail startups like Everlane) limit their potential customer base.

 

3) I don't see large, hidden sources of value, like large earnings growth obfuscated by money-loosing lines of business that can be cut away.

 

That said, I think they will be fine. IBM still looks pretty cheep and everything has a price. 12-13x earnings seems pretty fair for this business, so my buy price would be around 8x. Doubt it gets there.

 

I think that one thing that could change my mind on this (I'm still researching this one) is if a large portion of revenue has migrated from a upfront-cost revenue model to an as-a-service revenue model. I'm not sure if I'm missing something here but IBM looks mediocre to good-ish, and certainly not world beating.

[ccplz]

The bear case:

 

While demand for automation and computerization is increasing, commoditization of same is faster. The value is much more in SaaS and IBM has no SaaS offerings, only Cloud-hosted, single-tenancy custom solutions, PaaS and IaaS, which are mostly commoditized. As a data point, a half year on the IBM Bluemix PaaS with four environments, 500K transactions per month and gigabytes of storage with web, IVR and mobile channels would cost about $10K. Not exactly a living wage for IBM compared to what it would have cost a decade ago.

 

IBM is big into cognitive, but there's precious little business model there yet. Transformative for sure, but how do you value that transformation in a meaningful way at the scale IBM considers real dollar value? Basically, discussions at IBM for new global opportunities have to be in the scale of a billion dollars before it gets into meaningful numbers. But this isn't a problem solely for IBM. In an age when anyone can get simply stunning amounts of infrastructure and software that's global, scaleable and informed by deep analytics for a few thousand dollars for half a year, where is there a lot of money? In a world where a very small and smart team with the right tools can figure out deeply difficult problems for clients that were intractable before, how do you scale a global business?

 

And there are places where IBM just doesn't understand the transformation of the business of many of its biggest customers. Utilities, electrical generation, fossil fuel resource extraction, automotive: these industries are being radically transformed by electrification of the grid and electrification of transportation, but IBM is stuck in the old paradigm with a lot of its clients instead of leading into the new paradigm. I see precious little insight by IBM in terms of real and valuable offerings to clients in those fields for where they are going instead of where they have been. IBM has to change faster now, just like everyone else.

 

 

[arcube]

Can the bulls (some of whom are bears on AMZN) give us a sense what they think the IV for IBM in their opinion is. Thank you and kind regards.

[dwy000]

Can the bulls (some of whom are bears on AMZN) give us a sense what they think the IV for IBM in their opinion is. Thank you and kind regards.

 

Just my back of the envelope view, I base it off of FCF.  For this year it is expected to be $13.5bn.  Assuming a 1-2% growth in free cash flow per year and a discount rate of 10% (reduced from my normal given the pay virtually all FCF out each year), with a 12x exit in 10 yrs that's a PV of $186bn or 40%+ above today's price.

 

Being extra conservative and using a 0 growth rate, a 12% discount rate (ie hurdle) and 10x exit multiple I get $130bn of market cap - ie. todays value. 

 

So I'm happy to make a conservative assumption of zero growth in FCF and get a 10-12% return with the growth in cash flow or multiple being all upside from there.

[ccplz]

Any justification for the growth rate assumptions? i.e. why are you assuming no decline in FCF / net income?

[KCLarkin]

This is a good interview (though the transcription is terrible). It the most bearish IBM analyst interviewing IBM's head of research. He does a good job of exploring the nuances that the "AWS is the death star" crowd ignore.

 

http://seekingalpha.com/article/3724946-international-business-machines-ibm-presents-at-credit-suisse-19th-annual-technology-media-and-telecom-brokers-conference-transcript?part=single

 

[TheAiGuy]

Initiated a small position today

[LowIQinvestor]

This is a good interview (though the transcription is terrible). It the most bearish IBM analyst interviewing IBM's head of research. He does a good job of exploring the nuances that the "AWS is the death star" crowd ignore.

 

http://seekingalpha.com/article/3724946-international-business-machines-ibm-presents-at-credit-suisse-19th-annual-technology-media-and-telecom-brokers-conference-transcript?part=single

 

 

Thanks for sharing this!

 

Helps clarify for me why the hybrid cloud will continue to be in demand. Also, like IBM's positioning in terms of uncovering and analyzing the growing amount of "dark data".

 

"Now specific to cloud, I think honestly too many people focus on just the infrastructure layer. Yes, that’s important, but that’s not where all the action is. All the action is really above that. And in the end, there’ll only be a few of us in the infrastructure business because it’s capital intensive. And some will remain sort of relegated to just the infrastructure layer. But the interesting place and the value in our minds, the way we think about it Kulbinder, is in the stack about it."

[TheAiGuy]

This is a good interview (though the transcription is terrible). It the most bearish IBM analyst interviewing IBM's head of research. He does a good job of exploring the nuances that the "AWS is the death star" crowd ignore.

 

http://seekingalpha.com/article/3724946-international-business-machines-ibm-presents-at-credit-suisse-19th-annual-technology-media-and-telecom-brokers-conference-transcript?part=single

 

 

Thanks for sharing this!

 

Helps clarify for me why the hybrid cloud will continue to be in demand. Also, like IBM's positioning in terms of uncovering and analyzing the growing amount of "dark data".

 

"Now specific to cloud, I think honestly too many people focus on just the infrastructure layer. Yes, that’s important, but that’s not where all the action is. All the action is really above that. And in the end, there’ll only be a few of us in the infrastructure business because it’s capital intensive. And some will remain sort of relegated to just the infrastructure layer. But the interesting place and the value in our minds, the way we think about it Kulbinder, is in the stack about it."

 

I also thought this was pretty good, thanks for sharing it.

 

Some thoughts: 1) A company that is growing at 30% a year at "good profitability" (reporting is vague, but I would guess this is something around 15% net, possibly higher, given IBM historical margins), should trade higher than 5.5x revenue, especially if a lot of that revenue is recurring and annuity based. IBM claims that their "strategic initiatives" has a run rate of $25B, growing 30% a year at "good profitability" -- the market cap of IBM is 5.5x times that revenue figure.

 

2) I'm wondering about the revenue implications about a switch from upfront sales to SaaS, PaaS and IaaS. "As a service revenue" is recurring, much like an annuity, but smaller year 1 payments than upfront sales. If IBM signs SaaS contracts, if even if these contracts have better economics than upfront sales, you could see a drop in revenue. I wonder if growth has been better than it looks as a result (on the other hand, you'd expect them to make a bigger deal of this point if it were true).

 

 

 

[KCLarkin]

1) A company that is growing at 30% a year at "good profitability" should trade higher than 5.5x revenue

 

The wrinkle is that Growth IBM is cannibalizing sales from Core IBM. When they renew a Core outsourcing contract, the new contract is a "cloud" contract and gets added to Growth IBM. So some of that growth is a mirage.

 

I'm wondering about the revenue implications about a switch from upfront sales to SaaS, PaaS and IaaS.

 

To some extent, you are seeing this effect in the IBM software revenue drop this year (as IBM gives more "flexibility" in it's enterprise license agreements). But it is important to note that IBM already has Monthly License Charge (MLC) billing as an option, so it is hard to tell how much of their software revenue is "one time charge". Pure play software companies tend to separate recurring revenue from licenses in their financials, but I haven't seen this for IBM.

[TheAiGuy]

1) A company that is growing at 30% a year at "good profitability" should trade higher than 5.5x revenue

 

The wrinkle is that Growth IBM is cannibalizing sales from Core IBM. When they renew a Core outsourcing contract, the new contract is a "cloud" contract and gets added to Growth IBM. So some of that growth is a mirage.

 

 

Yeah, but that doesn't really matter. One way to think of the value of the company as a whole is to imagine that IBM is made of two companies NewCo and OldCo and NewCo is growing rapidly and is profitable while OldCo is in terminal decline and is in runoff. Almost all of the value on a prospective basis for the business is as a whole is NewCo, so what I care about is how big NewCo becomes after the runoff of OldCo. I don't really care about cannibilzation b/c if NewCo cannibalizes all of OldCo's revenue in 10years and then doesn't grow, then NewCo is worth ~4-5x revenue (depending on profitability), which a little below IBM's current marketcap.

 

Its mostly a thought exercise, what I really care about is if the New Lines of business will grow large enough to supplant the earnings of the old ones.

 

To some extent, you are seeing this effect in the IBM software revenue drop this year (as IBM gives more "flexibility" in it's enterprise license agreements). But it is important to note that IBM already has Monthly License Charge (MLC) billing as an option, so it is hard to tell how much of their software revenue is "one time charge". Pure play software companies tend to separate recurring revenue from licenses in their financials, but I haven't seen this for IBM.

 

thanks, that's helpful

[scorpioncapital]

I would argue NewCo and OldCo are the same thing if you see IBM as a very powerful client advisory firm and the two divisions customers are the same ones. Then it's a porting of product and related products, more akin to capital expenditure to offer more legroom in airplanes or faster broadband speeds in a cable co.

 

 

[TheAiGuy]

I would argue NewCo and OldCo are the same thing if you see IBM as a very powerful client advisory firm and the two divisions customers are the same ones. Then it's a porting of product and related products, more akin to capital expenditure to offer more legroom in airplanes or faster broadband speeds in a cable co.

 

Yeah, that's probably right.

[KCLarkin]

This is a good interview (though the transcription is terrible). It is the most bearish IBM analyst interviewing IBM's head of research. He does a good job of exploring the nuances that the "AWS is the death star" crowd ignore.

 

http://seekingalpha.com/article/3724946-international-business-machines-ibm-presents-at-credit-suisse-19th-annual-technology-media-and-telecom-brokers-conference-transcript?part=single

 

For me, this was the key:

But if we continue to build stacks and we continue to go into industry domains and provide higher and higher value solutions versus just infrastructure, we believe that we’ll be able to sustain and mostly likely, expand our margins.

 

When you look at large cap enterprise IT, they are almost entirely focused on horizontal solutions. IBM is almost uniquely qualified to create solutions for large verticals. Combine services, Watson, data, cloud, software, and hardware and you can imagine some very lucrative niches. And when you look at their recent acquisition history, you can see they are betting very heavily on verticals. This is not a new strategy for IBM (they built the SABRE airline reservation system in the 60s). But the emergence of mobile, cloud, and big data make this a very large opportunity for IBM.

 

When you look at their client roster, you can see which verticals they will target:

- > 90 of top 100 global banks

- 92 of top 100 healthcare orgs

- 9 of top 10 oil companies

- 9 of top 10 telecoms

- 22 of top consumer products

- 80% of top 50 retailers

- >225 state and local governments

- airlines

 

 

 

 

[LongTermView]

When you look at their client roster, you can see which verticals they will target:

- > 90 of top 100 global banks

- 92 of top 100 healthcare orgs

- 9 of top 10 oil companies

- 9 of top 10 telecoms

- 22 of top consumer products

- 80% of top 50 retailers

- >225 state and local governments

- airlines

 

These clients roster numbers are impressive.

[HWWProject]

I'll offer my 10-year financial review of IBM's transition from low-margin hardware into higher value software and consulting, including an assessment of a key Buffett metric - returns on tangible capital. 

 

http://healthywealthywiseproject.com/2015/12/one-chart-one-video-explains-warren-buffetts-love-ibm/

 

 

IBM bought PriceWaterhouseCoopers consulting back in 2002, doubling the number of employees.  Consulting firms have very high returns on tangible capital and I believe Buffett sees IBM more like an Accenture (this was mentioned by another in this thread).  So they're a unique combination of research and business consulting.  My analysis does not include full-year 2015 which has obvious been challenging.  But if you believe the long-term story then IBM offers good value here.

 

 

[ccplz]

I'll offer my 10-year financial review of IBM's transition from low-margin hardware into higher value software and consulting, including an assessment of a key Buffett metric - returns on tangible capital. 

 

http://healthywealthywiseproject.com/2015/12/one-chart-one-video-explains-warren-buffetts-love-ibm/

 

 

 

"Never, ever invest in the present. It doesn’t matter what a company is earning, what they have earned. You have to visualize the situation 18 months from now, and whatever that is, that’s where the stock will be, not where it is today. And too many people tend to look at the present, oh this is a great company, they’ve done this or this central bank is doing all the right things. But you have to look to the future. If you invest in the present, you’re going to be run over. "

[HWWProject]

"Never, ever invest in the present. It doesn’t matter what a company is earning, what they have earned. You have to visualize the situation 18 months from now, and whatever that is, that’s where the stock will be, not where it is today. And too many people tend to look at the present, oh this is a great company, they’ve done this or this central bank is doing all the right things. But you have to look to the future. If you invest in the present, you’re going to be run over. "

 

Good advice no argument here.  But not the point of my article.  My purpose was to take something Buffett said in an interview and put some numbers to it in order to understand how he thinks.  Throughout his shareholder letters Buffett states the importance of returns on tangible capital, both on an annual basis and a 5-year rolling basis for retained earnings.

[cubsfan]

HWW - that is an excellent chart. Very helpful in understanding the ROC.

[TheAiGuy]

I disagree that IBM has "infinite returns on tangible capital." The have infinite returns on tangible equity but that's an accounting fiction. The company has large and ongoing capital needs in the form of R&D and M&A -- that's Billions of dollars of investment that doesn't show up on the balance sheet b/c it is expensed and not capitalized.

[HWWProject]

I disagree that IBM has "infinite returns on tangible capital." The have infinite returns on tangible equity but that's an accounting fiction. The company has large and ongoing capital needs in the form of R&D and M&A -- that's Billions of dollars of investment that doesn't show up on the balance sheet b/c it is expensed and not capitalized.

 

I won't get in to how I calculate 'tangible capital employed' but I'll say that it should be at the top of every value investor's metrics.  Buffett has mentioned it going back to 1979 LTS in various ways.  It is analogous to Greenblatt's magic formula 'ROIC' measure for a quality company.

[TheAiGuy]

I disagree that IBM has "infinite returns on tangible capital." The have infinite returns on tangible equity but that's an accounting fiction. The company has large and ongoing capital needs in the form of R&D and M&A -- that's Billions of dollars of investment that doesn't show up on the balance sheet b/c it is expensed and not capitalized.

 

I won't get in to how I calculate 'tangible capital employed' but I'll say that it should be at the top of every value investor's metrics.  Buffett has mentioned it going back to 1979 LTS in various ways.  It is analogous to Greenblatt's magic formula 'ROIC' measure for a quality company.

 

I'd actually love to hear how you are considering "tangible capital employed." I typically take total assets and subtract non interest bearing debt (ala this book: http://www.amazon.com/Profit-Dollars-Earnings-Curtis-Symonds/dp/0814453767/ref=sr_1_1?s=books&ie=UTF8&qid=1450293944&sr=1-1&keywords=Profit+Dollars+%26+Earnings+Sense) but for IBM, I would want to consider the R&D spend in that as well.

[scorpioncapital]

tangible capital employed goes to the heart of the business. Truly a distinguishing measure that tells you what is necessary for a business to make money, what is discretionary, what are the economics.

[TheAiGuy]

tangible capital employed goes to the heart of the business. Truly a distinguishing measure that tells you what is necessary for a business to make money, what is discretionary, what are the economics.

 

Yeah, but that's a fuzzy measure that's not defined -- I agree with your definition but without a specific way of measuring it, at minimum in a gross ballparks way it's sort of, you know, a worthless platitude.

[rpadebet]

"Never, ever invest in the present. It doesn’t matter what a company is earning, what they have earned. You have to visualize the situation 18 months from now, and whatever that is, that’s where the stock will be, not where it is today. And too many people tend to look at the present, oh this is a great company, they’ve done this or this central bank is doing all the right things. But you have to look to the future. If you invest in the present, you’re going to be run over. "

 

Good advice no argument here.  But not the point of my article.  My purpose was to take something Buffett said in an interview and put some numbers to it in order to understand how he thinks.  Throughout his shareholder letters Buffett states the importance of returns on tangible capital, both on an annual basis and a 5-year rolling basis for retained earnings.

 

HWWProject,

Thanks for laying this out clearly.

 

It is basically saying IBM is shifting from low ROE business to a very high ROE business. I thought this part was known by investors, but I maybe wrong.

 

The attraction of this is, if you buy at today's prices, the earnings yield you earn today will eventually converge to that high ROE, if you hold it long enough. This is a matter of math again. No arguments here.

 

The key assumption though is " you have to hold long enough". WEB can hold.

 

But can the business generate this high ROE that long? Is the moat strong enough to allow that? If revenue keeps falling, they have to earn higher margins or reduce capital faster to maintain the ROE. There is a minimum level of capital which is going to be required, even for a consulting services business, so capital cannot go to zero. Consulting margins for other firms seem to be around 20%(IBM may be able to get higher because of scale, but I would be surprised if it is too high), so you are probably limited by competition there too. Point is ROE is high, but not infinite.

 

Revenue sustainability is key here. For an investor to experience a payoff close to the ROE, revenues need to be sustained for a long enough period.

 

The question therefore again comes back to, are IBM niches/ relationships strong enough to allow this to happen in face of strong competition?

 

The quantitative analysis is alright here, the business analysis is the tricky part.

 

Maybe, we need to run the next level of math and figure out how long we need the revenues to sustain in the worst case scenario, before earnings yield converges to ROE. Then figure out if IBM can ward off competition that long at least. Given WEBs conviction here, it seems to me he thinks there is enough time.