Warren Buffett Is Missing Red Flags At IBM

Jun.11.14 | About: International Business (IBM)

Summary

IBM has a market capitalization of $186 billion and pays a dividend of 2.4%.

While many investors watch the EPS figure, they may be ignoring the large amounts of cash invested in receivables and financing arrangements.

Amazon is disrupting not only the retail industry, but also tech juggernauts such as IBM.

Warren Buffett acolytes are well aware that Berkshire Hathaway (NYSE:BRK.B) owns 6.3% of International Business Machines Corporation (NYSE:IBM). I recently explored Amazon.com (NASDAQ:AMZN) and Wal-Mart (NYSE:WMT) utilizing a financial ratio known as the Cash Conversion Cycle to show the disruption caused in the retail industry. With all due respect to Mr. Buffett and the fabulous team he has built at Berkshire, IBM shareholders should focus on other factors than the EPS figure trumpeted by IBM management.

The scope of this article will highlight the disruption in IBM's business model.

First, An Illuminating Example

IBM has three core segments: services, software, and hardware. Thanks to cooperation among segments, the relationship with the customer should be symbiotic. For example, if IBM retains Starbucks (NASDAQ:SBUX) as a client, then IBM will advise various strategies to capture more business. A fictional example works like this: IBM recommends that Starbucks enter Zimbabwe, a foreign market ripe for consolidation. IBM will supply the servers and the applications that run on them, and then charge for the system's upkeep. So, in one relationship, IBM can handle the datacenter, business process outsourcing, application management, consulting and systems integration.

However, a decline in one of these three segments can hobble IBM. As more customers get their computing done cheaply in the cloud, IBM is selling less hardware, which imperils its high-margin software products. To continue the prior fictional example, Starbucks might decide to use Amazon's cloud services for their entrance into the Zimbabwe coffee market. Is this scenario realistic?

Has The AMZN Competitive Pressure Hurt IBM?

FYE 12/31/13

FYE 12/31/12

Amounts in Millions of $

$99,751

$104,507

Sales (Includes Services, Sales and Financing)

$31,836

$30,578

All receivables (Notes, Accounts and Financing receivables)

116.5

106.8

(NYSE:A) Days receivables {(Receivables/Sales)*365}

FYE 12/31/13

FYE 12/31/12

$51,246

$54,209

Cost of Sales

$2,310

$2,287

Inventory

16.5

15.4

(NYSE:B) Days inventory {(Inventory/Cost of Sales)*365}

FYE 12/31/13

FYE 12/31/12

$51,246

$54,209

Cost of Sales

$7,461

$7,952

Accounts Payable

53.1

53.5

(NYSE:C) Payable Days {(Acct. payable/Cost of Sales)*365}

79.8

68.7

Cash conversion cycle {a+b-c}

Click to enlarge

The cash conversion cycle is the amount of time between a company spending cash and receiving cash per each sale. It is a measure of efficiency and how long cash is tied up in working capital.

Remember, in this article, I show the Cash Conversion Cycle for AMZN as negative. The above chart shows that IBM has tied up more cash in receivables in FY 13, which resulted in a worse cash conversion cycle when compared to FY 12.

In 2013, AMZN held inventory for 37 days plus 23 days to collect receivables or 60 days in total. AMZN pays accounts payable in 74 days, thus achieving a negative cash conversion cycle. For AMZN, Accounts Payable is an unencumbered source of value, and it comes without any interest costs. AMZN can dictate terms to suppliers, and then invest the float in other projects. However, for many investors and analysts, it is unclear whether AMZN is reinvesting the float into profitable projects!

Amazon Beats Out IBM For A Recent CIA Contract

Exhibit one in this debate should be a February 2013 contract the CIA awarded to AMZN. After it became clear that IBM bid less than Amazon, government auditors became involved. When the GAO reviewed the award, documents showed the CIA's opinion of IBM was tepid at best. The agency had large concerns about IBM's ability to handle responses to usage spikes, and it rated the company's technical demonstration as "marginal." Overall, the CIA concluded, IBM was a high-risk choice. A federal judge ruled in October 2013 that with the "overall inferiority of its proposal," IBM "lacked any chance of winning" the contract.

Mr. Buffett may want to revisit his thesis for purchasing IBM. On CNBC, Buffett essentially argued that that no one ever got fired for buying IBM. In the above CIA contract case, this was not true.

The Chinese Government Takes A Swipe

China is currently pressuring its banks to remove high-end servers made by IBM and replace them with a local brand. The Bloomberg report said Chinese government agencies including the People's Bank of China, are reviewing whether Chinese commercial banks' reliance on the IBM servers compromised the country's financial security.

Conclusion

IBM's systems business is struggling. The company is at the end of its main- frame cycle, and the corporate sector is shifting to cloud computing offerings from Microsoft, Amazon and Google. The market for servers may also remain tough in China, where growth has slowed and economic reforms might crimp purchases by State Owned Enterprises, which are some of IBM's largest customers. Despite these headwinds, good performances by software and business services segments, and stock repurchases lifted earnings per share in FY 13.

Further, I conclude that AMZN gets to hold on to more of their supplier's cash, effectively borrowing it from suppliers. IBM does not have this same business model for value creation. By sitting on a supplier invoice for an additional three weeks, AMZN has a incredible source of cash when multiplied over $74 billion in annual sales.

Due to the challenges mentioned above, I continue to find shares of IBM as unattractive. Though Buffett feels that IBM is one of the strongest brands in the IT sector, its prominence may be fleeting. Buffett admires how entrenched IBM had become in the world's IT departments, citing the BNSF railroad as a prime example. Buffet felt that IBM was like an auditor or a law firm, and very difficult to "fire." I don't concur with Buffett's appraisal of IBM's competitive strengths.

This article is the opinion of the author and does not represent investment advice.

Disclosure: The author is long WMT, BRK.B. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.