A Weird Misconception About IBM

May. 1.13 | About: International Business (IBM)

One of the few times I have disclosed a stock purchase in real time happened on April 19, 2013, when I disclosed that I had purchased IBM (NYSE:IBM) at $190 per share.

Shares of IBM had fallen almost 10% in response to the news that net income had fallen by a percent (yes, one percent) and revenue had fallen by 5%. It kind of makes you wonder about a long-term investor's ability to handle adversity: back in the day, a young Warren Buffett was actually making his first stock purchase while the United States military was engaged in the Battle of Midway during WWII. Some days, I can't help but wonder how these investors selling IBM during a 1% drop in net income would have fared if they were investing in the early 1940s.

Anyway, the most interesting thing about the sharp fall in IBM's stock price is the fact that it was joined by a reassurance from IBM management that IBM's target of $16.70 in earnings this year remains unchanged. Think about that: IBM, a powerhouse company that is trading below its typical P/E ratio of the past decade, fell a further 10% even though the company was likely to increase earnings per share from $14.37 to $16.78. That's one of the wild things about the fall that IBM stock experienced: the stock was undervalued by traditional P/E metrics, and the earnings per share was expected to increase at a steady clip even taking into account the net income and revenue dip as reported in the first quarter of 2013.

Certainly, if IBM were to experience something like 10% annual revenue declines for the next decade, it would be fair to say that shareholders might be in trouble. But it is odd that people assume that robust revenue growth must somehow be a part of IBM's long-term growth story.

The two weirdest criticisms I have ever heard about IBM are the following: 1) IBM is a "buyback" company, and that model is unsustainable, and 2) I won't invest in IBM because the revenues hardly grow.

The 2003 to 2012 period illustrates how IBM shareholders can build wealth even without material gains in revenue generated.

Let's look at the figures. Okay, in 2003, IBM generated $89 billion revenue. In 2012, IBM generated $104 billion in revenue. Over an almost decade time frame, IBM only managed to grow its total revenue about 15-20%. According to the people highly critical of IBM's slow growing revenue stream, this is supposed to spell trouble for shareholders, right?

Well, let's look at what happened. In 2003, IBM generated $4.34 per share in earnings, paid out $0.63 in dividends, and traded between $73 and $94 per share. In 2012, IBM generated $14.37 in earnings, paid out $3.30 in dividends, and traded between $177 and $211 per share. Any way you slice it, shareholders had a good decade. The earnings just about tripled. The dividends quintupled. And the stock price doubled. The company managed to do all of these things despite only growing revenue by a total of 15-20% over that time frame.

The secret is that the company reduced the share count from just under 1.7 billion pieces into just over 1.1 billion pieces. There is nothing unsustainable about taking big chunks of your cash flow and retiring the stock. The problem with most corporate America buybacks is the fact that a meaningful amount of stock is not actually retired, but in the case of IBM, the share count is steadily shrinking. As long as the shares continue to be retired, stagnating revenue can prove to be a relatively small obstacle on the path to wealth creation for IBM shareholders.

Certainly, top-line earnings growth and revenue growth would facilitate the creation of wealth for IBM shareholders. The misconception, though, is when we elevate revenue growth to some kind of "sine qua non" status that is essential for IBM to be a decent investment. There's nothing wrong with being a buyback company if you do it right. The IBM dividend checks that have quintupled this past decade get cashed at the bank just the same regardless of whether they were produced by a dwindling share count or robust top-line growth. The point I want you to keep in mind is this: since 2003, revenue at IBM grew modestly, and the company had an extensive buyback commitment, and neither of these circumstances prevented IBM shareholders from generating very real wealth over the past 10 years.

Disclosure: I am long IBM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.