... the environment in which IBM competes has suddenly and fundamentally changed
IBM, in Alsin's view is too engaged in marketing and constructing what he calls "backyard computing power plants" while cloud computing has become more efficient. According to Alsin's viewpoint, IBM stock should be sold, and he does not see why Berkshire Hathaway (BRK.A) continues to hold the company's stock.
Mr. Alsin's letter is all the more interesting, given the rise in opposing views on IBM. Another Seeking Alpha author, Mycroft, wrote an interesting article titled, IBM: Stanley Druckenmiller Vs. Warren Buffett, Who Is Right? Mycroft points to Druckenmiller's view, that Amazon (AMZN) Web Services is defeating IBM's business.
I find the debate intriguing since I thought Berkshire's investment in IBM, announced in November 2011, was a good move. As of September 30, 2013 IBM was Berkshire Hathaway's third top holding, ranking 13.7% of Berkshire's portfolio. Placing the computer giant behind top holding Wells Fargo (WFC) and Coca-Cola (KO).
Berkshire Hathaway's IBM investment currently amounts to about $12.25B, down from $12.61B, on September 30th, 2013. Berkshire's total portfolio was $92B as of the last 13-F filed. Berkshire's 68.1M shares of IBM should generate $258.8M in dividends a year.
Take a look at Berkshire's three top holdings by market cap.:
IBM topped above the $230B level Wells Fargo currently enjoys; however, IBM has hit turbulence. IBM's market cap. is currently sliding below, what appears to be, a key point of resistance: The $200B market cap. level.
Let's look at Berkshire's current top three holdings' quarterly net income:
You may see why IBM appears to be a good complement to Wells Fargo and Coca-Cola. IBM averages $4B net income a quarter, furthermore the chart shows IBM has performed consistently. Though investors need to wonder how the company will continue to perform.
Now, take a look at the direction of Berkshire's top three holdings' shares outstanding:
Now let's turn to the all important dividends; keep in mind Berkshire Hathaway does not always reinvest dividends:
IBM has the least shares outstanding of the three companies, and the lowest dividend yield, currently.
By dividing the number of shares Berkshire owns, by each company's total outstanding shares, you will see Berkshire owns less than 10% of each company:
|shares owned by Berkshire / total shares outstanding||% owned by Berkshire Hathaway|
|Wells Fargo||463.13M / 5.268B||8.79%|
|Coca-Cola||400M / 4.416B||9.05%|
|IBM||68.121M / 1.068B||6.37%|
So, Berkshire owns more of The Coca-Cola Company, than it does Wells Fargo or IBM.
One of the reasons I like IBM in the group, is because the company adds diversification. Though, I believe Mr. Alsin has a good point about Amazon. If Berkshire had decided to invest in Amazon over IBM, the short-term gain may have been much better.
We do not know how Amazon would have performed if Berkshire purchased it instead, or in addition to IBM. Even though Amazon's stock has outperformed IBM's, I do not believe IBM is a lesser quality company. This is the nature of long-term performance and long-term investing.
Amazon Made Investors More Than IBM
Amazon's gains have been extraordinary, and Amazon is engaged in a very successful business. Still, some consider Amazon to be risky because the company's P/E is off the charts:
As you see, the charting tool has trouble displaying Amazon's P/E. IBM on the other hand, according to some investing strategies, appears undervalued. This is because the company's P/E is well below 20.
While everything (such as earnings, revenue growth, return on invested capital, etc.) can point to one company being a better investment than another; in real life, the underdog can still win the race. This is why, ideally I like some exposure to many quality companies, rather than taking one side of the IBM/Amazon debate, I'd prefer exposure to both companies.
So, What About Big Blue?
Long-term IBM investors got a boost when Berkshire jumped into Big Blue. IBM employs around 430,000 people; however a few thousand employees were laid off recently.
I view the trials and tribulations of IBM to be fairly normal, and consider the company to be a heavyweight in every sense of the term. While IBM has taken a few hits, the underlying business is still generating strong profit.
Berkshire Hathaway seems to adhere to a certain school of thought; the company leans towards investments with strong dividends and strong financials. Those who are bearish on IBM seem to be reacting to the older company's lack of dominance in newer technological fields, such as cloud computing. Though IBM offers cloud services, as Mr. Alsin points out, Amazon Web Services has beat IBM out on newer contracts.
IBM investors reacted negatively to the company's most recent earnings; though, the line that stands out most to me is:
GAAP Results: Net income: $4.0 billion, up 6%
Investors, financial writers and stock promoters / demoters can spin a company many different ways. However, as an investor I am interested in profitability. So, let's look to earnings for a second:
It is true Amazon's stock has done much better, look at Amazon's EBITDA on its own:
Now, let's just look at IBM:
Since 2012, IBM's EBITDA has been flat and has receded, while Amazon's has increased greatly. Though, you have to account for the vast difference in dollar figures we're looking at here.
IBM's EBITDA is around $22B, Amazon's recently jumped from under $2B to $3.4B. For IBM to have made a similar leap, the company's EBITDA would have needed to go to around $44B, or up 92% since the beginning of 2012. Instead IBM's EBITDA is up 80% since 2006, a far more gradual climb than Amazon's 580% increase since 2006.
IBM Survived By Being Fittest, Likely Not Bird Food Today
Mr. Alsin made a comparison between IBM and moths, who were assailed:
... the white moth/black moth comparison from 19th century London. The rapid buildup of soot due to industrialization led to the white moth population getting wiped out. Against a black backdrop, it was easy for birds to find white-moth lunch.
In the comparison, IBM is supposed to be likened to the white moths (which were actually lighter peppered moths.)
The analogy is interesting to keep in mind; though as of yet IBM has not experienced nearly the decline in business, that would prompt me to consider comparisons to the peppered moths. The company has about $10.2B cash and equivalents, $36.1B in debt, and $16.1B net income annually. Though, clearly Mr. Alsin's point is valid, Amazon is supercharged; the notion of IBM's extinction is very extreme, and in my view unrealistic.
IBM currently pulls in more net income in one quarter, than Amazon's annual EBITDA. Amazon's meteoric rise has pushed its market cap. to $180B, closing in on IBM's $195B. Amazon's $70B annual revenue is also racing towards IBM's $101B.
However, at the end of the day IBM offers services and products that are different than Amazon's. Amazon is competitive in certain important sectors, though. While IBM has repurchased shares and pays a dividend, Amazon shareholders have seen much better performance.
IBM Has Not Grown Like Amazon, Recently
Though IBM did not see a 92% increase in EBITDA since early 2012, like Amazon, the company is bringing home the bacon. Not only has IBM maintained a strong level of profitability, the company has engaged in very intelligent efforts to use technology to fight problems, like diseases and crime.
While I like both IBM and Amazon, I do find some of IBM's antics to be curious. For instance when the CIA chose Amazon's cloud computing service, for a major $600M contract, IBM appealed and tried to fight the decision. IBM lost their appeal, and the argument made IBM look like a sore loser.
Additionally, IBM huffed and puffed at the very popular former governor of Indiana, over a canceled contract for $1.3B. Sure, emotions run high when it comes to a $600M deal, or a $1.3B deal that does not go through. However, it does seem IBM needs to accept the fact business is competitive.
As an IBM investor, I do not want IBM to just roll over and give business away. Though, I recognize several states have very large contracts with IBM, and particularly in the case of the CIA contract, I do not believe IBM should have tried to second guess their customer.
IBM did recently receive a $1B Interior Department cloud computing contract:
The award is a coup following IBM's loss to Amazon.com Inc. in the competition for a four-year, $600 million cloud contract with the Central Intelligence Agency.
Though, I have to imagine former governor Mitch Daniels, who now leads Purdue University might be looking for other service providers after his experience with IBM. The best way for IBM to compete with Amazon is not in a courtroom, it is in the marketplace, in my opinion. Especially given IBM's current, very unique status as the third top holding of Berkshire Hathaway, a company greatly respected for excellence in investing, it seems important for IBM to rise to the challenge.
IBM Appears To Be Engaged Intelligently
You see how easy it could be to spin all of the subplots here? You have to understand, I've held IBM for a few years, and I started investing in the company before Berkshire Hathaway. Though, I have invested in Berkshire Hathaway longer than I have been in IBM.
I also like Microsoft (MSFT), Intel (INTC), Apple (AAPL) and Adobe (ADBE). In addition I like Amazon, while some investors have been quick to criticize Amazon, I've liked it simply because the service provided by Amazon.com appears to be very strong. Conversely, I'm the first to point out that some of Microsoft's competing services are weak.
I particularly like Intel and IBM because these companies seem to make very strong efforts to improve and promote science and health fields. Apple does also, and Microsoft's chairman runs the largest medical foundation in the world. I find these companies simultaneously make good products, have varying degrees of effective financial performance (at any given time) and they also try to apply technology to raise the quality of life across the globe. This is the single reason why I would go with Microsoft, Intel, Apple or IBM over a company that does not take on such causes, any day.
IBM, for instance is working to use artificial intelligence to help doctors identify cancers. The Watson computer system (named for IBM co-founder Thomas Watson Sr.) which was promoted on the game show Jeopardy, has been tested at Sloan-Kettering and MD Anderson. The computer system has been programmed to be able to answer over 5,000 questions a doctor might have about a medical condition.
Watson uses natural language capabilities, hypothesis generation, and evidence-based learning to support medical professionals as they make decisions. For example, a physician can use Watson to assist in diagnosing and treating patients. First the physician might pose a query to the system, describing symptoms and other related factors. Watson begins by parsing the input to identify the key pieces of information.
Additionally IBM's current homepage prominently features a project to donate a "computer's downtime" to "mapping cancer markers."
You see IBM has been around for over 100 years, Amazon has been around for almost 20 years. At some point Amazon will likely hit a top, the company will have to decide whether to introduce a dividend, buyback shares or both.
IBM has already been there, and has already done that, as the saying goes. There are aspects of the business that could be stronger and areas of the business that just downright aren't working. Though, for now the company is making over $1B a month in net income, while Amazon is making just a few million on average.
Conversely, IBM has more debt than cash, Amazon has more cash than debt. Of course, now Amazon is almost $400 a share, the bulls think, perhaps it will continue upwards; the bears have almost given up on it. However, what I'm seeing is IBM continuing to pull in boat loads of cash (keep in mind the company does have debt to pay,) and IBM continuing to aggressively drum up business (though, I'm also seeing some questionable sportsmanship.)
IBM Appears To Adapt
Obviously an important part of investing is to try to recognize the companies that could take off. However, large investors may be looking for companies they really want to own, and companies they believe are valued correctly. Investors should keep in mind Berkshire Hathaway owns insurance companies, candy companies and a railroad. Currently Berkshire is amassing a large investment in DaVita Healthcare (DVA) a dialysis company; these are businesses that could potentially benefit from IBM's services.
Furthermore, the comparison made by Mr. Alsin about natural selection, while important, does not seem to fully apply to IBM. Over the course of a century IBM has evolved and adapted, indeed IBM is working on a foundation it laid. To a large extent, Amazon is working on a foundation originally laid by IBM, also.
This is not to say that an older company should rest on its laurels. However, I do not see IBM resting, or relaxing, I see the company actively engaged in advancing technology. A David and Goliath parallel between Amazon and IBM does not seem to fit either, since Amazon currently has a $180B market cap. to IBM's $195B.
While IBM has already grown, and Amazon is still growing at an incredible rate, I believe an important question to raise is: How much is Amazon really worth? If you were to really consider acquiring Amazon what would the price tag be?
Those with bearish sentiments towards IBM, also must ask the same question of Big Blue. A company with $22.5B EBITDA is worth something; for instance Facebook currently has a $115B market cap., $3.2B EBITDA, $9.3B cash and equivalents, and $575M in debt.
Compared to Amazon and Facebook, technically some investors would argue IBM is undervalued. With Facebook and Amazon's much lower earnings and net income relative to IBM, I'm inclined to ask what the market would value them at if they brought in $4B a quarter, net income, like IBM?
It appears one of the stronger comparisons to be made between IBM and a tech peer is to Google (GOOG). Unlike Amazon and Facebook, Google has averaged $3B net income a quarter over the past 4 quarters. Google has also experienced strong growth over the past few years. With a 28.84 P/E and EPS of 36.75, Google seems to have stronger financial similarities.
Notice Amazon's revenue tops Google's, though Google has been much more profitable. While Google and Amazon have experienced significant growth, according to this chart IBM has maintained a level of dominance.
Let's look at the bigger picture, by extending the time frame to the maximum:
We can only try to forecast what this picture will look like in 20 years. However, it is a very important financial comparison for those interested in the differing views on IBM currently.
I can see why some investors might favor Amazon, or Google. Pay particular attention to the economic downturn in late 2008 and 2009, IBM's revenue did not go below $90B. Clearly Amazon's and Google's revenue soared, far more than IBM's, in terms of percentage, since the economic rebound. Though IBM has been doing more annual revenue than them since the mid-1990s.
Each investor will look at these companies' performances differently. It is very important to consider the possible weaknesses in IBM's business model, per Mr. Alsin's article; however, I do not believe the answer is to disown IBM. The company has adapted before, and I believe can continue to adapt.
If you have any thoughts on IBM and mounting competition, please leave a comment below.
Additional disclosure: I am long IBM and Berkshire Hathaway corporate bonds. I also have exposure to Amazon stock through mutual funds. This article is not a recommendation to buy or sell, please consult a financial adviser to determine proper allocations, if any, to technology companies.