After reading the company's annual reports for 50 years and choosing not to invest, the legendary Warren Buffett "got a different slant" on IBM's (IBM) 2010 annual report and bought a stake worth more than $11 billion in 2011. Since then, Buffett has continued to add to what is now his portfolio's third largest position representing more than 17% of his portfolio, SEC filings show. Ever since the Berkshire Hathaway Inc. (BRK.B) CEO revealed that his company had bought IBM in November 2011, there have been tons of articles written- both on this site and elsewhere- on why the Oracle of Omaha has been loading up his portfolio with IBM stock and what qualities Buffett so loves about the company. However, I think that in some ways, IBM is quite unlike Buffett's other investments and some of its attributes even undermine Buffett's earlier stated investment principles. In this article, I will discuss how IBM differs from Warren Buffett's other major investments and then give my verdict on whether Buffett made a mistake buying IBM.
IBM is a Tech Company
Part of the reason why Buffett buying IBM made so many headlines was the fact that IBM is a technology company and Buffett is notoriously known to be averse to investing in tech companies. The major reason behind this is that the future of technology is inherently hard to predict and continues to change, whereas Buffett likes businesses that are very stable. To quote the great man himself:
"I look for businesses in which I think I can predict what they're going to look like in ten or 15 or 20 years… Take Wrigley's chewing gum. I don't think the Internet is going to change how people are going to chew gum… I don't think it will change whether people shave or how they shave."
"The best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago."
Now let's look at IBM. You can argue that when it comes to tech, IBM is no Apple (AAPL) or Facebook (FB); IBM is the most stable of IT companies. But nonetheless, IBM is a tech company and its business mix continues to change with changes in technology. IBM continues to divest away from hardware to focus on investing in higher margin software and services segments. And even within these segments, IBM's business continues to change with changes in technology, an example of which is the recent focus on the 'Cloud' and 'Smarter Planet' initiatives. Compare this to Buffett's other major investments like Coca Cola Co. (KO), Procter & Gamble Co. (PG), Wal Mart Stores Inc. (WMT), Wells Fargo (WFC) and American Express (AXP) whose basic business and products are pretty much the same as they were a decade ago and are expected to remain the same for the next decade or so. The same cannot be said about IBM with much certainty.
Total Debt/Equity (mrq)
Source: Yahoo Finance, Forbes, warrenbuffettstockportfolio.com
The table above gives an overview of the key statistics of the top six positions by size in the Berkshire Hathaway portfolio. As you can see, IBM's return on equity, one of the key metrics for Buffett, is exceptionally high. However, that comes at a cost of a fairly high debt to equity ratio in absolute terms as well as relative to the other non-financial companies. IBM's high level of debt is also reflected in its high interest coverage ratio. IBM's very high Price/Book ratio also tells us that the exceptional return on equity may well be more than priced in. The major reason for IBM's high debt to equity ratio as well as the elevated return on equity is the management's continued commitment to share repurchases which reduces the shareholders' equity thereby inflating the debt/equity ratio and the return on equity. The company intends to return $70 billion back to its shareholders according to its 2015 road map in the form of dividends and share repurchases. This creates a contradiction. Warren Buffett is a big fan of share buybacks because it increases the existing shareholders' ownership in the company. But at the same time, Buffett is not a big fan of growth through debt and leverage. At this point in time when the interest rates are at historically low levels, share repurchases financed through debt will help to grow the EPS; but if and when the interest rates start to rise, IBM may have some trouble servicing its debt. It's hard to say when, but there may come a time when the market starts to price in the increased riskiness due to the high debt to equity ratio. And with the further buybacks promised in IBM's 2015 roadmap, IBM does not appear to be in a hurry to act on its increasing debt/equity ratio any time soon.
A close look at IBM's balance sheet suggests that IBM does not appear to have a very healthy balance sheet especially when compared to Buffett's other major investments. IBM's book value per share (BVPS), a measure of the minimum value the shareholders can expect to get in case of liquidation, has been stagnant to say the least. In fact IBM is the only company among Buffett's top six positions which has a lower BVPS today as compared to 2008 (see chart above); other companies in the chart below have steadily rising BVPS. However, this did not stop IBM's price from almost doubling during this period.
Source: Company Balance Sheet
Moreover, not only does IBM have negative net tangible assets, the tangible book value continues to become more negative as the years pass by. Among Buffett's other major investments, only Proctor & Gamble has negative net tangible assets; the difference with IBM is that P&G's tangible book value is negative but rising as is its overall book value per share.
IBM is also the only company among these six whose revenue declined during 2012.
Has Buffett Made a Mistake?
Before Buffett fans jump the gun on me for questioning the investment genius, read my view below. Due to the reasons stated above, I do think that IBM is pretty different to Buffett's investments over the past years. However, there are two ways to look at these differences:
- Warren Buffett is wrong to invest to a tech company with close to twice as much debt as equity.
- Despite the differences to other investments, Buffett values something in IBM that is more than what is apparent in basic financial statement analysis.
Despite his amazing history of successful investments, Buffett can be wrong- he is no god. However, I would rather side with option two.
Warren Buffett makes his investment decisions based on a company's annual reports, not merely its financial statements. This is important because the annual report, in addition to containing the financial statements, gives a broad overview of the top management's perspective of the company's financial performance over the past year as well as the management's view of the company's future prospects and targets. Unlike Buffett, I haven't been reading annual reports for the past fifty years. However, for the past few years that I have, I'm always looking forward to IBM's report because it conveys the management's strategic vision about the company in a very eloquent manner. If you read IBM's annual report 2010, the very report after reading which Buffett decided to buy IBM stock, you will notice the clarity of vision from IBM's top management on the very first page. After informing the investor about IBM's strong financial results, Chairman and CEO Samuel Palmisano writes in his letter to the shareholders: "These results were made possible by decisions and actions that we undertook a decade ago, based on where we believed the world was shifting. But even more, they are a reflection of the mindset, ambitions and values that have guided IBM since its inception, 100 years ago." The chairman's letter then goes on to explain how IBM was keenly aware and therefore took advantage of various changes in its operating environment over the past decade as well as giving a roadmap of IBM's EPS target and its drivers for 2015. And this is the crux of Buffett's investment thesis on IBM. Buffett appreciates this clarity in vision and definition of targets, noting, "I don't think there's any company that's…done a better job of laying out where they're going to go and then having gone there." After revealing his decision to buy IBM stock, Buffett noted that as an IT services company, IBM had that stickiness and indispensability to many large corporate and government institutions worldwide.
Yes IBM is a tech company, but with a certain aura of stability which comes from the fact that IBM's management has consistently been two steps ahead of the changes in technology as well as changes in other environmental factors. Despite being a tech company, the one constant about IBM is that it has successfully reinvented itself to adapt to a constantly changing environment for more than 100 years of its history. "By becoming a very different company from what we were just a few years ago, we have become much more like the company IBM has been for most of its history", as Palmisano puts it in his letter to the shareholders in 2010. I think this puts to bed the "Buffett doesn't invest in tech because technology changes" narrative.
IBM's management set itself certain realistic but challenging targets in its 2010 EPS road map, primarily to increase the operating EPS to $10-11 per share which it was able to meet successfully. This enhances the investors' trust in the company's management to meet its 2015 road map targets as well. I believe this trust is the reason why IBM investors were not worried by a marginal decrease in IBM's revenue for the year 2012. In fact in terms of the 2015 road map, the breakup of revenue numbers for 2012 doesn't look bad: growth markets' revenue was up 7% after adjusting for currency and the revenue from its major growth drivers, Business Analytics, Smarter Planet and Cloud grew 13%, 25% and 80% respectively which in turn drove growth in profits despite flat overall revenue growth. The free cash flow figure also showed an impressive 9.6% growth to $18.2 billion.
IBM's negative net tangible assets are also not a big issue, especially in light of the 2015 road map which targets $20 billion in acquisitions. The main intangible asset on its balance sheet, goodwill, is just the additional price over the book value paid for an acquisition. As long as these acquisitions help drive revenue and profit growth for IBM, the negative net tangible assets figure should not be a concern for investors.
IBM's debt to equity ratio may seem out of proportions compared to Buffett's other investments but should not be much of a worry as long as IBM is generating sufficient cash to be able to cover its debt. IBM's long term debt of $24.2 billion is just 1.3 times its free cash flow. In the meantime IBM is taking advantage of its top notch credit rating as well as rock bottom interest rates in the US to lever up its returns. Just recently, IBM issued $2 billion in floating rate of which $1 billion of notes due 2015 yielded 2 basis points below libor, which is a remarkable testament of the investors' confidence in IBM's ability to repay its debts. Moreover, according to the Fed's guidance, interest rates are not going to rise anytime soon. If and when they do rise, IBM can always prioritize debt reduction over share repurchases to cut down its debt.
IBM's financial statements appear to show how the company is quite different to its peers in Buffett's investment basket. However, IBM's annual reports, on which Buffett bases his investment decision, show what Buffett likes about IBM: A brilliantly managed company with competitive advantages which have made it an integral part in the efficient operation of large organizations worldwide, creating barriers to entry in this business and thereby ensuring excellent long term growth prospects, much like Buffett's other top investments.