The stock market makes mistakes -- it misprices stocks, after all -- but those mistakes always get corrected in due course. Part of my job as a money manager is to be quicker than the market, to spot the mispriced stocks (where value exceeds price by a wide margin) before the market has a chance to correct the mistake.
That's essentially what I did a year ago when I posted my Top 10 list for 2012. Ten out of 10 stocks have outperformed, up an average 71% vs. the S&P 500 return of 14%. (If you'd like to see the record, click here).
Mispricing happens the other way as well, with stocks where price exceeds value by a wide margin. Such is the case with IBM (NYSE:IBM), a stock priced too high given the structural deficiencies in its operating model. Unfortunately for IBM shareholders -- and I am one, indirectly, through ownership of Berkshire Hathaway (NYSE:BRK.B) -- this is a story that looks as if it will end badly.
Pushing on a String
For several years now, IBM has been plowing shareholder capital into buying back shares. IBM has bought 800 million shares on the open market since 2004, retiring 500 million (most of the difference went to management). It's an aggressive buyback program, and it works wonders for earnings per share as long as you have a healthy, vibrant operating model.
Ah, but here's the rub: IBM does not have a healthy, vibrant operating model. Organic revenue growth is nonexistent, and its attempt to "buy" growth via acquisition has failed miserably. The company spent $17 billion in acquisitions over the last five years, yet 2012 revenue will come in at the same level it was in 2008, about $103 billion. It's certainly a red flag, and it suggests that IBM's vaunted sales force is having a tough time convincing customers to sign new contracts.
Margins have expanded dramatically in recent years, with operating margins soaring from 16% to 27%. It's the result of cost cutting, not because IBM has pricing power (deflation is a powerful trend in IT). The impetus for expanded margins: The jobs of about 30,000 U.S.-based employees have been outsourced, primarily to India. In 2005, U.S.-based workers comprised more than 40% of IBM's workforce; today it's 21%. Out of 433,000 worldwide employees, there are only 92,000 employees left in the U.S., while there are over 120,000 in India.
But let's set aside the outsourcing issue, as it's understandably sensitive -- those 30,000 "resource actions" (IBM's euphemism for layoffs) came during a deep and difficult recession. I don't want to distract from the core issue here -- namely, that IBM's operating model is structurally flawed.
To help paint the picture of how and why IBM is in trouble, consider the operating model of Costco (NASDAQ:COST), a company that takes care of shareholders and customers and employees. Costco's limit on markups is 15%. As it drives efficiencies and lowers costs the savings are automatically passed on to customers, which in turn helps create a loyal, if not fanatical, customer base. In terms of taking care of its employees, look at some name tags the next time you're in the store: You'll see "Since 1999" and "Since 2003" and the like. There's a reason Costco employees stay on the job: because they're treated well. A floor worker can make well over $40,000 per year with health benefits, much more than at competitors' stores.
By outsourcing jobs to India (and to a lesser extent, Brazil and China) IBM has driven a huge increase in operating efficiency, dramatically lowering costs. Unlike Costco, however, it doesn't pass the savings on to customers. It inures to the benefit of shareholders, which, of course, includes management.
Customers are now paying a 100% markup on cost, much higher than in years past. Even if we assume a large markup in software (23% of total sales), it still leaves services and hardware with markups of 70%, by my estimates. My guess is that such rich markups are part of the reason why IBM has been unable to generate and sustain organic sales growth.
By now you should be getting the gist of the story: Hyper-aggressive management, incentivized by a boatload of stock options, sets a $20 earnings goal for 2015 to be achieved through a combination of cost cuts (outsourcing) and stock buybacks.
But there's a big, obnoxious assumption embedded right in the middle of that equation: revenue. Absent revenue growth, management's plan doesn't work. It can't cut its way to $20 per share in earnings and it's having a helluva time buying revenue growth via acquisitions. The fact that IBM's revenue line is so demonstrably poor raises one's suspicion about the value proposition offered to customers. If customers were happy with the value of the service packages they sign up for, wouldn't there be some decent organic growth?
A New Paradigm for Information Technology
We're in the early days of a massive paradigm shift, as computing power shifts to the cloud. It's a wonderful development for customers, as computing power is about to get a whole lot cheaper. New entrants such as Amazon (NASDAQ:AMZN) Web Services, Salesforce.com (NYSE:CRM), Rackspace (NYSE:RAX), and many others are racking up impressive sales gains as they grab share.
Where is IBM in all this cloud-based excitement? Therein lies the problem: IBM's operating model can't compete with the up-and-comers. IBM has been quite good at driving down costs, but it hasn't passed the savings on to customers -- and now it's too late. Now, if management changes course and suddenly becomes customer-centric, margins will drop and the stock will implode. So management is stuck trying to protect a $103 billion revenue stream while maintaining 100% markups. It's a strategy that's certain to bleed customers -- which is the case now, masked to some extent by $17 billion in acquisitions.
What Should IBM Management Do?
In my view, IBM management doesn't have a whole lot of options. The competitive landscape has changed almost overnight, leaving IBM's core franchise exposed. IBM's model of selling end-to-end solutions with rich margins is becoming less competitive. In the short term, financial engineering can help IBM meet earnings targets. It can prop up the revenue line with more acquisitions and the net income line with more share buybacks; it can even tuck expense into "restructuring charges," which are likely to balloon in the quarters to come.
But the ultimate resolution will be the same. This is an operating model in need of an overhaul, and the sooner that happens, the better.