IBM – Will Buffett Be Proven Right?
|March 15, 2016||Posted by Oddmund Grøtte under Stock Analysis|
Share price when article published: 142 USD
I’m a great admirer of Warren Buffett. I really like his humble and common sense approach to investing. Of course, he is not infallible and do make mistakes. So far his big investment in IBM in 2010 has not been profitable. Buffett wrote in the annual shareholder letter in 2011 that he hoped the share price would languish the coming years. Why did he write that? Because IBM has a high cashflow yield. This enables IBM to buy back shares and his stake in the future profits increases. When IBM traded in the 120s in February the cashflow yield was 11% (!).
So why isn’t the share price much higher? Is IBM in big trouble? Either this is a bargain or the market sees a lot of troubles down the road. Personally I believe IBM is an extremely good buy below 150 if you have a timeframe of some years. I bought IBM back in February at 134. Unfortunately I was too greedy and wanted to have it cheaper when it was at 117. Good thing I finally gave in and bought at 134.
By the way, IBM is one Buffett’s big 4 (the other I believe is KO, AXP and WFC).
Let’s have a look at IBM:
Here are the cold facts from 2006 until 2016:
|Revenue USD Mil||-1.11328|
|Gross Margin %||1.742296|
|Operating Income USD Mil||2.777754|
|Operating Margin %||3.976642|
|Net Income USD Mil||3.344818|
|Earnings Per Share USD||8.186017|
|Operating Cash Flow USD Mil||1.251443|
|Free Cash Flow Per Share USD||7.084725|
Basically all numbers are good, even though revenue is falling. That is because IBM is trying to get out of low margin businesses and is divesting. Basically all of its hardware stuff is sold. As a result of this turnaround its revenue has fallen a lot from 2013 until 2015. It will most likely decrease again in 2016, but at a much lower rate. Remember that currency headwind is also part of the problem here (strong USD).
As you can see the revenue is falling but free cashflow is not dropping significantly:
Over the last 10 years IBM has managed to turn 14% of every dollar in revenue into free cashflow. That is a pretty good number.
IBM has good return on capital:
Balance sheet analysis:
IBM had at 31st of December 2015 33 bn in long-term interest bearing debt. Total liabilities were 96 bn. Still, IBM has no problem serving its debt.
Excess cash is negative.
IBM is a “high yielder” and for soon to be pensioners the stock could give a decent income. IBM is no dividend aristocrat (25 years of rising dividends) but at 20 years it most likely soon will be. The last time IBM lowered dividend were in the early nineties when the company faced problems and the share price halved. The chart below indicates payout ratio is increasing but that is all according to the board’s plan. IBM wants to give back 80-85% of free cashflow as dividend or buybacks. At a share price of 142 the dividend yield is 3.66% (1.3 USD per quarter). IBM will highly likely increase dividend every year in the next 5-10 years.
Since 2005 IBM has bought back almost 40% of its shares. Substantial layoffs in recent years has further helped grow earnings and cashflow.
Stock price today: 142 USD
Here is chart of the relative valuation over the last 10 years:
Blue line is PE and pink is P/FCF.
IBM is currently trading in the lower half. Considering todays multiple of 10-11 there seems to be room for more upside in IBM.
Using the average net income the last 3 years gives a PE 10. Free cashflow has the same ratio. In other words, the stock is still cheap. Now, a lot has been said in media about the falling revenue. I like to play with numbers and below you find a table calculating EPS until 2025 with 1% growth in both earnings and free cashflow per year. The row called 2015 is the base numbers and taken from the last report. Dividend is set to increase 2% per year (probably more but remember issued shares are going down so dividend will increase more in % per share), the column called “rest” is free cashflow after dividend, the column “buybacks” is 70% of free cashflow after dividend (in million shares and using average stock price of 175 for buybacks) and “issued shares” is of course outstanding shares after buybacks. Remember, IBM is exiting low margin business to focus on high margin business.
|Net income||FCF||Dividend||Rest||Buybacks||shares||EPS||dividend per share|
As you can see, even with a PE of 10 IBM will trade at 230 USD in 2025, and this is excluding dividends received of about 60 USD per share for the period (and dividend received is very conservatively calculated). Assuming a more normal PE of about 13, total CAGR will be around 10%. Considering this is conservative and we are having zero interest for the time being, I think this is pretty good.
As a conclusion my take is that IBM will outperform the market in the next coming years. Both because of rising EPS but just as much from higher multiples.
As a sidenote: IBM has disappointed on most of the quarterly earnings presentations over the last two years, mainly because of falling revenue, and share price has dropped. Hence, don’t be surprised if it happens again. Rather, it might be a good buying opportunity.
The biggest risk is if the divestiture does not go according to plan. Revenue is falling, and if margins go down from here stock also could go down. However, I believe the margin of safety is so big that the downside is limited.
I own shares of IBM