With the recent drop of IBM to under $175/share, some long-term owners of IBM may be wondering whether it is worth holding on to a stock that has greatly underperformed the market this year. The cause of the drop in stock price was the fear induced by the sixth consecutive quarter with revenue declines for IBM. Is it time to be greedy when others are fearful? Let us revisit Buffett's large IBM share purchase in November 2011 and try to understand his logic in making such a large long-term commitment to Big Blue.
Two years ago, Buffett shocked the business world by purchasing $10.7 billion worth of IBM shares, which was Berkshire Hathaway's second largest investment after Coke (NYSE:KO) at the time. What was even more surprising was that IBM had doubled in market value the two years prior to Buffett's investment and was trading at all-time highs when Buffett made his purchase. Bloomberg likened the IBM purchase to Buffett's famous Coke investment from 1988 when Coke was trading near its all-time highs. Buffett does not generally like to talk up his investments because he likes to buy more of his favorite companies as the market ignores them. However, he has given us enough clues to understand why he has placed a conviction bet on IBM for the long-term.
LACK OF REVENUE GROWTH DOES NOT BOTHER BUFFETT
After the most recent quarterly reports, analysts and the investing community have been fixated on dipping revenues due to special circumstances in China as well as the use by IBM management of share repurchases to contribute to earnings per share growth. Would these things bother Buffett? These same issues were addressed in the following exchange on CNBC in 2011, where Buffett was bullish on IBM in spite of lack of revenue growth and "financial sleight of hand" by IBM growing earnings per share growth through stock repurchases and tax rates:
JOE: It's interesting with IBM how many times I've read that their top-line growth, they haven't had any for 10 years, and the only way they get earnings per share to go up, they're buying back stock so they're reducing the number of shares outstanding. So EPS goes up and it's all financial sleight of hand. They've moved some facilities offshore so they've got a lower tax rate. Every time they beat expectations or had higher earnings, I always saw the analysts say, yeah, but it was because there's fewer shares outstanding and because of a lower tax rate. It was-and it's amazing that after all that, here we are with you at this very bullish case.
BUFFETT: Yeah. And, Joe, there's nothing wrong with fewer shares outstanding.
BUFFETT: If they get it down to where there's 64 million shares outstanding [this is the number that Buffett owns], I'll be very happy.
IBM'S WIDE MOAT - STRONG BRAND AND CUSTOMER STICKINESS
Rather than focus on short-term swings in revenues, Buffett tends to make his long-term large commitments in companies that he believes have durable competitive advantages or "moats" that allows the company to earn high profits consistently. In his CNBC interview, Buffett described some of his thoughts on IBM's durable competitive advantages. He spoke of two in particular that warrant mentioning here - IBM's brand name and the stickiness of the customer relationship with IBM. Both of these competitive advantages remain intact in spite of the revenue miss that Wall Street is currently focused on. IBM is still on track to earn billions of dollars in profit this year from its loyal customers all over the world.
The first competitive advantage Buffett mentioned was the power of the IBM brand name. He told a story of how he ran a company that used to compete with IBM, but had trouble competing with the trusted IBM brand name. "We actually started-I was chairman of the board, believe it or not, of a tech company one time, and computers used to use zillions of tab cards and IBM in 1956 or '7 signed a consent decree and they had to get rid of half the capacity. So two friends of mine, one was a lawyer and one was an insurance agent, read the newspaper and they went into the tab card business and I went in with them. And we did a terrific job and built a nice little company. But every time we went into a place to sell them our tab cards at a lower price and with better delivery than IBM, the purchasing agent would say, nobody's ever gotten fired from buying-by buying from IBM. I mean, we probably heard that about a thousand times. That's not as strong now, but I imagine as you go around the world that there are-there's a fair amount of presumption in many places that if you're with IBM, that you stick with them, and that if you haven't been with anybody, you're developing things, that you certainly give them a fair shot at the business."
Second, Buffett spoke about the stickiness of IBM's business with its customers. Buffett has a track record of investing in service companies such as advertising firms and realizes the power (and profitability) of the sticky client relationship. According to Buffett, IBM is less a pure tech company than a services company "that helps IT departments do their jobs better." Speaking on the stickiness of service firms such as IBM, Buffett said,
...you know, we work with a given auditor, we work with a given law firm. That doesn't mean we're happy every minute of every day about everything they do but it is a big deal for a big company to change auditors, change law firms. The IT departments, I-you know, we've got dozens and dozens of IT departments at Berkshire. I don't know how they run. I mean, but we went around and asked them and you find out that there's-they very much get working hand in glove with suppliers. And that doesn't-that doesn't mean things won't change but it does mean that there's a lot of continuity to it. And then I think as you go around the world, IBM, in the most recent quarter, reported double-digit gains in 40 countries. Now, I would imagine if you're in some country around the world and you're developing your IT department, you're probably going to feel more comfortable with IBM than with many companies.
ROADMAP, REPURCHASES, CAPITAL ALLOCATION
Other than IBM's durable competitive advantages in brand strength and customer loyalty, Buffett has praised IBM's capital allocation policies and roadmaps to creating shareholder wealth. Buffett likes the commitments made by IBM in its 2015 roadmap outlining how management will allocate capital and increase earnings per share by repurchasing shares, making targeted acquisitions, shifting to higher margin businesses, and divesting commodity-type businesses. Specifically, Buffett seems to love the massive repurchase of shares that IBM has been making over the past few years and has committed to continue into the future. In his 2011 annual shareholder letter, Buffett explained the logic of why he hoped IBM shares languished over the next five years. He said that because IBM had planned on spending $50 billion or so on share repurchases through 2015, if the shares languished at $200 during the period, IBM could retire many more shares than if the shares averaged $300 during the same period. The large reduction in shares could make the remaining shareholders much wealthier over the long run because each shareholder will own a larger percentage of IBM's earnings stream. Buffett said that,
In the end, the success of our IBM investment will be determined primarily by its future earnings. But an important secondary factor will be how many shares the company purchases with the substantial sums it is likely to devote to this activity.
It is almost as if Buffett knew that IBM would languish over the next few years while the company repurchased a massive number of shares. He is playing the long-game and realizes that the remaining shareholders will greatly benefit once the market gives IBM recognition for its competitive advantages, high value products, and sustained growth in earnings per share.
Buffett purchased his original shares for an average of about $165 two years ago. He has bought additional shares for prices in the $170s and $180s. You can buy the stock now for only 10 dollars more even though earnings per share have increased substantially since that time. At some point (hopefully not too soon), the lasting earnings power of IBM due to its wide moat should cause the shares to increase substantially in value after the huge share repurchases that IBM has committed to. This is a great buying opportunity to pick up this top international company at a discount price.