One of my friends from Seeking Alpha, Robert Allan Schwartz, recently pointed out to me this article in the Wall Street Journal that was sharply critical of IBM as a long-term investment, with the brunt of the criticism aimed at IBM’s monstrous buyback program, which typically retires 1-2% of the company’s shares outstanding in a given quarter. You should probably read the article yourself, but the gist of the piece was this: when IBM invests into its business, it achieves growth of 18.1%. When it does buybacks, it achieves growth of 6.5%. The commitment to buybacks at the expense of fresh investments in the business is a form of corporate cowardice that exhibits “playing not to lose” thinking and resting on laurels, rather than the boldness and imaginativeness you’d like to see in order to achieve significant corporate growth. Very provocative article.
Since I’ve written a lot about IBM in the past if you followed me from Seeking Alpha, I wanted to post my reaction to the sharply negative IBM piece, which you can do with what you will.
Even though I disagreed with certain parts, I thought it was an excellent article. It was a very contrarian thesis, and they had the hard numbers to back it up. But before we etch the letters “I B M” right below “R I P” on the corporate tombstone, there are a couple of things to consider.
First, the article notes that IBM’s buyback is delivering 6.5% annual returns, while its investment in net business assets have grown at 18.1%. That disparity may not be as bad as you think, if you reach the conclusion that IBM’s stock is currently undervalued and IBM’s management team is good at ballparking general ranges of expected profitability for their investments.
Let’s say that someone believes, as I do, that IBM’s business is worth the equivalent of $220-$235 per share. If that premise is correct, then IBM is somewhere around 20% undervalued, and the management is acting intelligently by repurchasing the stock while borrowing costs are low. When the other investors collectively recognize IBM’s worth and push the price up to $220+, then suddenly the buyback will look more brilliant as it will achieve average returns of nearly 10% (as opposed to 6.5%), depending on the time the stock price reflects its true worth. That’s the psychologically tough thing about buybacks–they rarely look intelligent when conducted. In fact, the more intelligent the move, perhaps the more ridiculed it will receive from the investor community.
The other thing worth considering is this: Perhaps IBM’s 18.1% returns on business investments are due to the fact that IBM’s management is being very selective about their capital expenditures. Perhaps that 18.1% is the product of spending discipline and restraint, and it would fall significantly if IBM invested more into business growth. It’s a counter factual: we will never know what would have happened if a buyback dollar got thrown into the business instead.
I know that liking IBM is currently unfashionable, but here is what I see: a company that is steadily increasing net business profits from its activities even without taking into account the buyback program. It made $7 billion in profits in 2003, and doubled profits by 2010 to over $14 billion. And now, profits are in the $16.5-$17.0 billion range. The buyback, though, has been the spike to the bunch because the share count gone from 1.7 billion or so to just a hare above 1.0 billion or so now. That’s why I think IBM will give you percentage dividend increases that, say, you won’t get from AT&T over the next decade. The current business model is “perpetually built” for 8-12% earnings per share growth, and a dividend growth rate that will slightly lag whatever that figure turns out to be.
I think this might be a case where people are letting the current stock price dictate the sentiment. When Johnson & Johnson was in the $60s about a year or so ago, people were trash-talking it non-stop. The way people criticized Johnson & Johnson’s recalls and manufacturing problems then is roughly parallel to the way that IBM’s stagnating revenue growth is being criticized now. However, with the price of J&J in the $90s, it’s once more the darling blue-chip that deserves a spot on the mantlepiece right next to Coca-Cola, Procter & Gamble, and ExxonMobil again. The company hasn’t changed, but the stock price did, and that shifted perceptions. If IBM currently traded at $225 per share, would the negative sentiment still carry the day on Wall Street? I doubt it.