Why Stan Druckenmiller Is Wrong On IBM

Nov.23.13 | About: International Business (IBM)

Stan Druckenmiller reportedly recommends to short IBM (NYSE:IBM), because he believes that its business would "be replaced." According to Druckenmiller, "IBM is old technology being replaced by cloud technology."

The quote is quite interesting and (at least apparently) convincing. IBM, having been incorporated 100 years ago, surely is an old company. It sells "old tech" like servers, develops the technological infrastructure of hospitals and banking networks, and provides IT consulting services to lots of enterprises around the world. This is certainly nothing that in our days could still sound exciting. Maybe ten years ago, but not now. A great many companies are in these businesses.

Hence, IBM's business one day will be replaced. I totally agree.

However, there is one element in this story that Druckenmiller (and not only him) tends to ignore: History.

Starting in the 1880s, various technologies came into existence that would form part of IBM's predecessor company. Julius E. Pitrat patented the computing scale in 1885; Alexander Dey invented the dial recorder (1888); in 1889, Herman Hollerith patented the Electric Tabulating Machine and Willard Bundy invented a time clock to record a worker's arrival and departure time on a paper tape.

On June 16, 1911, the above technologies and their respective companies were merged by Charles Ranlett Flint to form the Computing-Tabulating-Recording Company (C-T-R). The New York City-based company manufactured and sold machinery ranging from commercial scales and industrial time recorders to meat and cheese slicers, along with tabulators and punched cards.

Flint recruited Thomas J. Watson, Sr., formerly of the National Cash Register Company, to help lead the company in 1914. The company soon focused on providing large-scale, custom-built tabulating solutions for businesses, leaving the market for small office products to others.

- Basically, in about 30 years only, the still young IBM had already changed its business model several times, introducing rapidly further innovations and leaving the older ones to others. And it would continue to change:

In 1963, IBM employees and computers helped NASA track the orbital flight of the Mercury astronauts. The latter half of that decade saw IBM continue its support of space exploration, with IBM participating in the 1965 Gemini flights, the 1966 Saturn flights, and the 1969 mission to land a man on the moon.

On April 7, 1964 IBM announced the first computer system family, the IBM System/360.

The IBM PC, originally designated IBM 5150, was introduced in 1981, and it soon became the industry standard. In 1991, IBM sold Lexmark. In 2005, the company sold its personal computer business to Lenovo.

Over time, IBM engineers have made several inventions that shaped our world:

  • Automated teller machine (ATM)
  • Floppy disk
  • Hard disk drive
  • Electronic keypunch
  • Magnetic stripe card
  • Virtual machine
  • Scanning tunneling microscope
  • Reduced instruction set computing
  • Relational database
  • Universal Product Code (UPC)
  • Financial swap
  • SABRE airline reservation system
  • Dynamic Random Access Memory (DRAM)
  • Watson artificial intelligence

(IBM's history is mostly based on Wikipedia's IBM article.)

Many of these inventions were first introduced by IBM and later left to others.

- Doesn't it seem like IBM, from time to time, wants some of its markets to be taken over by others? Understanding the rapidly changing nature of technological progress very well, rather than falling behind its competitors, the company wants to run far ahead. Its business does not get replaced, it lets itself get replaced, or, to be even more precise: IBM replaces its own businesses from time to time. While IBM sold its PC business to Lenovo, HP and Dell still kept theirs. They did not do anything to replace it and are now left with businesses of far less value. And IBM is far ahead when it comes to moving the core business to software and services.

Hence, when I hear about a business of IBM "getting replaced," I'm not worried at all. On the contrary: This is potentially great news and could preannounce another innovation that might shape our world.

As I have laid out in other articles, IBM is currently as cheap as in the middle of the financial crisis in April 2009, its recurring revenues alone would justify the current share price and its free cash flow per share has been rising steadily over the past years.

Stan Druckenmiller is totally wrong, when he affirms that free cash flow is "sort of $10 billion run rate." In the first 9 months of 2013, IBM made about $6.6 billion of free cash flow (and this figure includes the one-time Q2 $1 billion workforce rebalancing charge). Considering that Q4 has always been IBM's strongest quarter with $9 billion of free cash flow in 2012 and $8.5 billion in 2011, almost certainly IBM will go far above Druckenmiller's $10 billion mark at the end of Q4. Probably he does not calculate free cash flow correctly, as unfortunately most people do.

Druckenmiller also seems to ignore the free cash flow projections made by IBM's management on the last conference call, which were far more optimistic than his:

"Now cash taxes, we believe now in 2014 will be a headwind of about $2 billion, but even including cash taxes, we would see our free cash flow growing by a little over $1 billion. So the operational profile within that in that 15% to 20% range and on that basis, free cash flow growing faster than net income.

Going to 2015, we would see that free cash flow - the inclusion of cash taxes, growing at about 15% to 20%, again free cash flow growing more rapidly than net income, and in 2015 that cash taxes should be a tailwind."

When he talks about Warren Buffett's investment rationale, Druckenmiller shows that it is him who does not understand IBM, considering the company just like any other "tech" business and thus victim to a rapidly changing environment. Buffett is probably far ahead of Druckenmiller in this respect, having understood the opportunistic, rapidly adapting business model of Big Blue.

All in all, Druckenmiller's case for shorting IBM sounds to me like many other short cases made by short-term traders: apparently, but only superficially convincing, perfect to move markets in the short-term, but fundamentally wrong.

So I am happy to "replace" other shareholders in IBM's shareholder register right now, as the opportunistic, always adapting, value investor like nature of IBM's business model seems to create the ideal investment for long-term stockholders and retirees searching solid inflation protection and decent growth potential with little downside risk.

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.