Many long-term investors have followed Warren Buffett into IBM (NYSE:IBM) on the "buyback thesis." In essence, while IBM has been struggling to grow revenues and profits, it has been aggressively buying back shares, thereby pushing up earning per share and the share price. It is in this vein that some actually cheered the drop following IBM's most recent quarter as it could repurchase a higher number of shares for the same amount of money. While I understand the logic in this thesis, I would not be a buyer of IBM here.
First, underlying business fundamentals matter. Rarely do companies in decline prove to be strong investments. Since 2008, IBM has been unable to grow revenue, and revenue has declined in six consecutive quarters. Importantly, during the last five years, IBM has spent over $17 billion on acquisitions. In other words, it has a negative organic growth rate as competitors like Salesforce.com (NYSE:CRM), SAP (NYSE:SAP), and Oracle (NYSE:ORCL) have taken share. CIOs have plenty of cloud and business service companies to choose from; it is no longer IBM and no one else. At some point, IBM needs to begin growing again if it is going to sustain cash flows.
While the company has been pivoting towards service, hardware is still a significant part of its business, and the company reported a truly stunning 40% drop in China hardware sales with sales in the emerging market down 22% overall in its most recent quarter. These trends have all been getting progressively worse. IBM is a company that has truly lost its mojo. The quarter lacked any signs of a turnaround, and I expect 2014 to bring negative year over year growth.
I believe a reason for this has been the company's dogmatic focus on its five year EPS roadmap. When companies focus on hitting near term earnings target, they often will push off investment or focus on financial engineering to deliver good short-term results with disastrous long-term consequences. Hewlett-Packard (NYSE:HPQ) under Mark Hurd is a good example of this. In no sector is this truer than in technology where heavy investment is required to maintain a competitive advantage. IBM would be better off throwing out its guidance, focus on the core business, and reposition the company for growth in the future. Instead, management continues to stick to its plan of pulling various levers, namely buybacks, to boost EPS while the business is on fire.
Investors should also remember that cash, not earnings, is used to repurchase shares. Further, we are all aware that there are many factors that can make net income look a little stronger or weaker while cash is an absolute figure. If the thesis for IBM is on cash being returned to shareholders, it makes sense to me to look at cash flow rather earnings, which I do in the following chart. In the table, I show I show operating cash flow, operating cash flow less cap-ex (free cash flow), and cash flow per share, based on the end of the year share count. I included 2009-2012 full year results, interim 2013 reported results, and projected full year 2013 results.
In the past five years, IBM has bought back nearly 20% of its shares, yet from 2009-2012 OCF per share only grew 9.4% while FCF per share grew a measly 4%. This slower growth rate has occurred thanks to a decline in OCF of 6% and a 10% drop in FCF. 2013 has shown a dramatic step down from 2012 as revenue trends worsen with FCF per share dropping to $11. Investors are owning a bigger piece of a shrinking pie, and as a consequence, the overall size of their individual piece is barely budging. With a five year negative growth rate, an optimistic projection would be for flat future growth, especially as deterioration tends to accelerate rather than flatten out. This would make the stock's 16.4 FCF multiple exceedingly expensive, providing a long run return of 6.1%. Historically, equities have had a discount rate of 8-9%. With $11 in FCF, that would translate to fair value for IBM of $138. If we were to assume that IBM could get back on track and grow at 1.5% annually, fair value would be $169, still a 6% discount to the current share price.
I think we would all agree that investors are not served well when a company pays too much to acquire another company because that is not an accretive use of cash. In a sense, isn't a share buyback simply an acquisition of itself? When IBM buys a share itself, it is no different than buying shares of a different company. If IBM announced a $10 billion acquisition of a company with negative organic growth, declining free cash flow, and a FCF multiple of 16.4 times, projecting an ROI of 6.1%, would you be happy? I believe the answer is no because that return is below the average equity investor's required rate and tech businesses in decline can be very costly and difficult to turn around. Why then do we commend IBM for repurchasing $10 billion of its own shares? Investors would be far better off if the company spent more money on its business or to acquire another company that is actually growing.
Now, some investors might argue a buyback is different than an acquisition of another company because it changes the supply/demand fundamentals of the stock. IBM shifts the demand curve by constantly buying shares while also continually shrinking the supply of available shares by retiring them in the Treasury. This is an interesting and valid perspective, rooted in incontrovertible macroeconomic theory. By buying back shares, IBM does make its stock more scarce, which could increase the price, and in fact over the past five years, there has been a general downward trend in daily volume in IBM shares (albeit overall trading volume has also been weak in this period), which is indicative of lower supply. I believe this supply argument gets to the fundamental question of how stocks are priced: by technical mechanics or by the underlying business fundamentals. I think the answer depends on an investor's time frame.
In the immediate term, pricing is defined by the supply and demand of shares. I would suggest you look no further than Twitter's (NYSE:TWTR) IPO where the price soared thanks to the low supply of shares offered and sold. In the long run though, I believe TWTR will trade inline with its business fundamentals because when a stock is seen as overvalued, buying interest can disappear, more than making up for low supply. IBM's buyback, by cutting the supply of shares, could boost the price in the near term, but I believe a stock can stay disconnected from fundamentals for only so long as investors have no interest in buying a stock that they expect to lose money in. IBM's buyback may be a catalyst for the near-term investor, but I do not believe that cutting the supply of shares can override changing business fundamentals to impact long run returns.
Therefore, IBM has a cash flow problem with declining cash flows offsetting the company's extremely large buyback program. IBM has no growth and is in organic decline, which suggests future cash flow erosion that will drag down shares. To get a fair rate of return, IBM shares should fall by at least 6% even under an optimistic view of its business. With a more reasonable forecast of flat revenue growth, its stock has 20% of downside. Warren Buffett rarely invests in tech companies, and I believe he will grow to regret buying this one. IBM is a sell.