Is Buffett A Liar?
Back in late 2011, I learned that Warren Buffett bought into (NYSE:IBM) to the tune of $10.7B at roughly $170 per share. Like many Buffett watchers, I was completely confused. This did not make any sense to me. To be perfectly honest, I felt a little bit betrayed.
In my experience, Buffett avoids technology companies. He sticks to his circle of competence. He only invests in what he understands. He likes to invest in businesses that don't change much over 15 to 20 years. He's looking for monopolies, competitive advantages and he likes economic moats. I could keep going, right?
In early 2012, I continued to experience severe cognitive dissonance about his investment. How could Buffett buy into a technology company like IBM given everything that he's said and done over the last 60 years or so? This was extremely frustrating.
I then realized that I need to take Charlie Munger's advice. I needed to invert the problem. I also realized that I needed to get beyond my first level thinking.
Charlie Munger to the Rescue
I decided to completely reverse my thinking. Invert, always invert! So, instead of trying to figure out the reasons why Buffett bought, I tried to figure out why Buffett would not invest in IBM.
Of course, the very first thing that came to mind was that IBM is a technology company. I also thought about the uncertain, shifting sands of technology. I thought about all the nimble competitors and the incredible pace of technological change. I thought about the innovator's dilemma and disruptive innovation. "IBM will die!"
But, something funny happened as a result. I realized that virtually all my negative arguments about IBM in the long term were related to technology.
There are relatively few negative arguments about IBM's management, their strategic planning, their brand, their market positioning, their margins, and so on. Again, I'm talking about the big picture and the long-term perspective, and obviously I'm guessing about Buffett's thinking here too.
So, here's the official dead moose on the table: IBM is a technology company and therefore do not invest. This was the #1 reason that Buffett should not have made the investment. Nearly everything "bad" about IBM comes down to that assumption.
Charlie Munger and Howard Marks: Second Level Thinking
So, let's take the result of our inverted thinking and apply second-level thinking.
First-level thinking says, "This is a technology company, so it's not attractive." Second-level thinking says, "This is not a technology company, so it might be attractive."
This shocked me but the process provided the result, so I ran with it. My unexpected result then forced me to completely rethink my assumptions about IBM.
IBM's 2011 and 2012 Annual Reports
I first downloaded IBM's 2011 Annual Report. I took a really close look, with a clear mind. And, I was specifically trying to ignore any thoughts of technology. Unfortunately, I failed. Although I was excited to see updates on revenue, margins, strategy and markets, I kept getting sucked into the blather related to technology in the form of business analytics, the Cloud, Smarter Planet, and the like. This was a failure for me.
I also read this on IBM's site shortly after:
"IBM is a globally integrated technology and consulting company headquartered in Armonk, New York."
That sure sounds like IBM sees itself as a technology company.
Although I was disappointed, I moved on to IBM's 2012 Annual Report. Within just 2 minutes, my entire perspective on IBM was transformed. Here's what jumped off the page at me:
"IBM is an innovation company. Both in what we do and in how we do it, we pursue continuous transformation - always remixing to higher value in our portfolio and skills, in the capabilities we deliver to our clients and in our own operations and management practices."
The focus is not on technology. There's no technical jargon. The mission is about innovation, transformation, and providing customer value.
Technology Solutions Versus Technology Company
I realized that it's true that IBM delivers results using technology. They sell packages of hardware, software, consulting and services. They apply best practices, technology models, and information technology outcomes. In this sense, I would agree with anyone that IBM is a technology company.
But, the value that they create for customers manifests when they sell risk reduction, business optimization and even entrepreneurial vision.
Putting this differently, technology is what everyone sees, but IBM's core value in the market is the innovation they provide. In this light, they sound more like a start up company than a $200B company.
Druckenmiller Has It All Wrong
On 23-November-2013, Stan Druckenmiller let the world know that he placed a bet against IBM. He's got his money on Amazon (NASDAQ:AMZN) and he loves Jeff Bezos. He bashed IBM for investing in stock buybacks instead of challenging companies like Amazon. Druckenmiller went on to say that technology isn't in Buffett's area of expertise. He also said:
"...investors who want to bet on innovation should buy shares of Google and those who want to bet against innovation should buy IBM shares."
Here's the thing. Although Amazon and Google (NASDAQ:GOOG) are outstanding companies, IBM is also highly innovative. IBM invents the future through R&D, patents, licensing and the direct application of knowledge and experience.
It's not just the $6B per year they invest in the future that matters. It's their innovation and the access customers get to IBM's entire ecosystem that matters. It smells a bit like insurance; businesses invest in IBM for stability, strength and security.
I believe the real key is that IBM isn't just an idea factory or think tank or patent machine. They apply innovation in the sense that entrepreneurs do; to increase value by taking customers to higher levels of productivity (using technology, but also much more).
Between the creative and entrepreneurial focus on innovation and also the decreases in their commodity information technology businesses, I'm able to "look through" IBM as a technology company. They are a unique animal, beyond the pigeonhole of technology.
The Annuity Business
As I've touched on previously, IBM provides innovation in the form of entrepreneurial solutions. However, once they provide value, they "lock in" customers and get paid over time. Putting it plainly, IBM has an enormous annuity business. In fact, as Early Retiree outlined it in this article:
"Almost 2/3 of profits are annuity based! This translates into $10.70 of the expected 2013 non-GAAP Operating EPS of $16.90."
(Sidebar: Early Retiree also points out that Druckenmiller is ignoring history. I agree, but it's not just history that proves Druckenmiller wrong.)
IBM enjoys billions in recurring revenues. That special revenue stream is misunderstood and undervalued. Annuity-based cash flows are predictable well into the future. In fact, back in 2007, IBM made it very clear that annuity content provides a "solid base" of business. That base continues to grow today and it will likely grow in the future.
Although IBM's overall sales dropped in Q3 2013, the big fall was in hardware (17% decline). Quite frankly, that appears temporary to me. Plus, hardware isn't an area of growth.
IBM maintained their $16.25 guidance for 2013. More importantly, in light of the "long tail" and the annuity business, services backlog rose 2% to $141B in Q3. For perspective, the backlog is equivalent to about 70% of IBM's market cap. This backlog and future cash flow appears to be heavily discounted, given its predictability and per share impact as buybacks continue.
Here's exactly why I'm bringing up the annuity business and the tremendous backlog. IBM is not selling commodity information technology one widget at a time. They continue to shift from low margin to high margin businesses. They keep growing stable, recurring revenue streams. And, they're doing it really well.
All of this provides me with an understanding of why Buffett would place such a large bet and why he wants IBM's stock price to languish for the next several years (see: 2011 Annual Report, Page 11). He wants a growing piece of their future cash, including their delicious annuity stream. That's simple for me to understand.
A Simple Way to Evaluate IBM's Future
In summary, I believe that once you look at IBM as an innovation company, versus strictly a technology company, it becomes an even more attractive opportunity at today's prices.
I've determined that IBM generates approximately $17 in owner earnings per share. To apply simple math, at 10x Owner Earnings, IBM is worth $170 per share. At 12x, it's worth $204 per share. At 15x, it's worth $255 per share. Depending on your view of the world, IBM is trading between fair value and a 30% discount based on numbers derived by my brute force calculations.