Warren Buffett's (Hypothetical) Answer To Arne Alsin's Letter On IBM

| About: International Business (IBM)

Dear Arne,

You know that I've read Dale Carnegie. So thank him for my reply.

You are a very smart guy and seem to have tons of smart certainties about future developments in the technology space. If I had your certainties, I would certainly not care about stocks like IBM (NYSE:IBM) or Amazon (NASDAQ:AMZN), as with these certainties you can make a lot more money elsewhere. However, I don't believe that it is smart to have certainties about future developments in the technology space. I don't have them and I don't think I need them. As I have laid out many times, my ideal investment is like shooting fish in a barrel, but after the barrel has been drained and the fish have quit flopping. I don't make projections. (See how my biographer Alice Schroeder explains this fact in a video.) You may think that this is not very smart, so let me explain the issue more precisely:

IBM makes about $18 billion of free cash flow every year. Just like that funny chap Stan Druckenmiller you might disagree on this calculation (although it recently has been excellently explained by your fellow Seeking Alpha contributor Early Retiree), so let's say they make only $15 billion. And let's presume this figure declines somewhat in the next few years. It won't go down fast, as IBM has a lot of recurring revenues that are locked in by multi-year contracts. Anyway, the stock will surely tank. It could go down to $120 or even lower. Presuming that IBM's management will be totally clueless and won't know how to squeeze some more money out of the record number of patents they register each and every year, the company will probably allocate most of that money to stock buybacks. Maybe $12 billion/year. At $120 per share, that's 100 million shares per year. I don't know 10 years from now, but I can be quite sure about 5 years from now: Under the above assumptions IBM will have made at least about $60-75 billion of free cash and will have bought back at the very least 400 million shares and paid some dividends. Let's say the company will make only $10 billion of free cash flow in 2018 (and Druckenmiller will finally be right). Assuming only little dilution through stock options (because of the declining stock price), there will be about 700 million shares outstanding. This means that FCF/share will come in at $14.30 - which is not very different from now. So I would still get an 8% FCF yield on my investment plus dividends, all in all probably about 10%. And this is under the most pessimistic assumptions. I don't need to know a thing about how the cloud sector will look like a few years from now and can still be pretty sure about my 10% yield.

Probably IBM will adapt itself to a changing environment like it has always done. It will find ways to invest profitably some of its cash. Its financing business enjoys returns on equity north of 40%. Africa, Asia, Latin America will grow and need to build their technological infrastructure. Europe will not be in recession mode forever.

Just because I like teaching so much, some further considerations on the Amazon-IBM battle:

A) Remember that it is not necessary to be the winner in order to be a good investment.

B) A company could be the winner, but still be a terrible investment.

C) This is no football game. Maybe neither of both will win, competition will continue, other companies will enter the arena, dynamics will change.

D) We should focus on what we know. We should not base our decisions on fantasies about things we can't know for sure.

The question who will win the cloud market - Amazon, IBM or others - is of little interest in my opinion. This is pure first-level thinking. Second-level thinking would be: "Everybody thinks IBM will lose the cloud battle and its stock will go down. But IBM will still make tons of free cash and will buy back its shares on the cheap. So in the end this is a win-win situation."

First-level thinking is your statement:

"The environment in which IBM competes has suddenly and fundamentally changed".

Second-level thinking would be: "Technological evolution has always brought about sudden change; this is exactly IBM's environment: IBM strives because technology changes, thus fundamental changes are the basic condition for IBM's success."

If you avoid IBM because of disruptive changes in its environment, it's like avoiding reinsurers because of earthquakes. But if there weren't any earthquakes, there would be less need for reinsurance in the first place.

You say:

Proprietary code is another barrier to entry that's going to the wayside. The wide availability of open source code is allowing small, nimble software startups to tackle just about any programming problem. It's why disruptive innovation in software is happening from the ground up, not from the top down.

This is actually a good example. Remember that IBM was among the first big software companies to support and develop open source applications. (Who said that uncle Warren didn't know a thing about software?!) IBM perfectly understood the disruptive nature of open source applications, that's why the company actually promoted it. Its perfect environment is disruption.

And here I'll stop. At my age one has to be careful with time.

Best regards,


P.S. By the way, I know that German weekly "Der Spiegel" very well. I tried to buy it many years ago.

(This letter is obviously my own invention. - Early Retiree)

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.