Should You Buy IBM Stock Now?

Some perspective on IBM: For the June 30th through September 30th 2013 period, IBM reported a profit of $3.68 per share. For the June 30th through September 30th 2014 period, IBM reported a profit of $3.68 per share. Each share of third-quarter profit is the same year-over-year. And, though, nobody is talking about it now, IBM is still expected to earn $16.04 in annual profit for 2014, compared to $14.94 last year. Though it has gone completely undiscussed in the past several days, IBM is still on target to post profit per share growth of 7% when you compare 2014 against 2013.

Why, then, is everyone speaking so negatively of IBM, which has the real-world impact of seeing the price decline by 15% over the past three months?

Five things primarily have been a cause for concern among people who have an ownership stake in the firm:

  1. The revenue for the third-quarter came in at $22.4 billion, which was lower than Wall Street expectations.
  2. The earnings per share missed by $0.63. The consensus estimate, taken as an average of Wall Street estimates that omit certain extremes, anticipated $4.31 per share in profit, rather than the $3.68 that materialized.
  3. IBM’s backlog fell 7%, however, the company still has $128 billion in servicing work to perform.
  4. The company has abandoned its roadmap (set by the previous CEO Sam Palmisano) to achieve $20.00 in earnings per share by 2015.
  5. Laying off employees has been a tool to achieve profit growth in recent years, and CEO Ginny Rometty indicated that will continue into the future. Obviously, this affects employee morale—it’s hard working for a place that regularly refers to employees as a cost, as in the phrase “The costs need to be cut.”

Every quarter it seems, some analysts on Wall Street get uncomfortable with IBM’s sluggish revenue reports. In an interview on CNBC, CEO Rometty mentioned that she would not disclose any conversation with Warren Buffett (who counts IBM among his “Big Four” investments, alongside Coca-Cola, American Express, and Wells Fargo), but anticipated he would say, “Focusing on revenue is like focusing on the empty calories.”

It is a distinction that matters—sometimes people forget that revenue calculations only refer to the amount of money that you take in. If you own an ice cream stand that sells 10,000 ice creams per summer for $3 each, you’re bringing in $30,000 in revenue. If you have to spend $25,000 hiring ice cream vendors, paying for the ice cream truck, and buying the ice cream in bulk from a vendor, your profit is $5,000. It is from that $5,000 you can extract from the business and pay your bills, go on vacation, or donate to charity. When fast-growing businesses can’t figure out why the company’s treasury isn’t overflowing with cash, it’s often referred to as “intoxication with sales” to describe a company’s undue focus on growing revenues rather than profits.

IBM is probably the biggest example of a company where revenue figures and profit figures do not closely align. This is because IBM has been growing profits by cutting costs and reducing the share count through large repurchases, rather than growing revenue. When I saw IBM’s downward price action since the earnings release, my reaction was “Really? How is this revenue report any different from all the other bad revenue reports we’ve seen over the past ten years?”

In 2004, IBM posted $96 billion in revenue. This year, IBM will post somewhere around $97 billion in revenue. There’s basically been no revenue growth over the past decade. Yet, costs have come down substantially due to productivity gains and layoffs (the morality of which is a very interesting side question that probably deserves its own post) so that IBM has doubled its profits over the past ten years, from $8.6 billion to a little over $17 billion. In addition to those growing profits, the company has reduced its share count from 1.6 billion to 997 million.

In other words, while revenue has stagnated at IBM for the past decade, this has concurrently happened: IBM went from generated $8.6 billion in profits that had to get divided into 1.6 billion pieces, to now generating $17 billion in annual profits that get divided into 997 million. That’s why the profits per share have gone from a little over $5 per share to almost $16 per share today. If you owned 100 shares of IBM in 2004, it was generating $500 in look-through profits on your behalf. If you spent each and every dividend over the past decade along the way, and were still sitting on those 100 shares, they would be producing $1,600 in profits on behalf of your ownership. That is assuming you did nothing to add to your position such as reinvest dividends—revenues stagnated, and your profits per share tripled.

The current dividend yield offered by IBM is a historical high; even during the Great Recession, the dividend yield average for the year was only 2.0%. The dividend has been growing at a rate of 19% annually over the past decade, and earnings have grown by 13% annually over that time. And revenues have stagnated over this ten-year interval—and yet, the earnings and dividends keep piling up (and despite a dividend growth rate that is growing quicker than profits, IBM still only boasts a payout ratio of 25%. This low payout ratio explains why the company has been able to retire and destroy so much stock over the past decade, making each share you own represent a greater claim on the company’s overall profits.

As CEO Rommetty pointed out, the company’s cloud operations have been growing at a 50% rate; the catch, though, is that it only accounts for $4.4 billion worth of the company’s business at the present time. The company has a profit margin of over 16%.

Moments like these with IBM, McDonald’s, and BP are useful in that they provide opportunities to gauge whether your personality gauges well with value investing. On almost every investing forum I’ve ever read, someone starts a conversation by way of introduction, saying, “I’m a value investor.” If you make that statement, and intend to do it properly, that means you are either buying companies during bad economic times in which just about every stock is declining by 20% or more, or you are buying a company during normal or good economic conditions that is working its way through problems. IBM is obviously a candidate for the latter situation.

When I was at Washington & Lee, I was friends with a very smart guy who routinely showed up five minutes late for class. One day, about halfway through the semester, the teacher got mad at his tardiness and chided him for his lateness. Sure, it’s better to arrive on time or early. Sure, it’s better for a company to grow revenue. But it’s not a requirement for a successful investment. The guy who regularly showed up late was plainly intelligent, and had established a pattern of both showing up late and doing well on the testing material. IBM plainly has some great profit sources ($18 billion in profit across over 1,000 product lines), and has established a pattern of reporting stagnating revenues while still growing profits per share.

This latest earnings report is the latest iteration in a trend that has been true for at least the past decade while the company still delivers satisfactory investment returns. The company is trading at something like 10x profits right now. That means, theoretically, the company could pay out $10 in profits to you as the shareholder for every $100 that you invest. The company wouldn’t do that, but it’s a nice exercise to remind you that you’re dealing with real profits that can be purchased at a cheap level. This 2.7% dividend yield is a generational high. The earnings per share keep climbing. This is a great opportunity to do some value investing, and let’s hope IBM’s executives retire even more stock now, while the price is low and the beneficial effect for shareholders can be greatest. This is the season for value investors to turn their eye towards IBM, McDonald’s, BP, and GlaxoSmithKline—they’re great companies working their way through problems that are very solvable and, frankly, not that bad when you consider the scope of their business operations.

 

 

 

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9 thoughts on “Should You Buy IBM Stock Now?

  1. says:

    Hi Tim,

    Thanks for your article. I’ll need to research IBM more deeply. Did you see the report from McDonald’s today? I own McDonald’s but am starting to worry a bit, as profits were flat, even when stripping out one-time items and currency effects. Not very inspiring, although I do try to maintain a long-term perspective. Just like to know your thoughts on that.

    Thanks

    Dave

  2. scchan_2009 says:

    I have recently bought some IBM shares (sadly it was before yesterday crash, as I could have gotten a better price), but I am still fully confident with IBM. Anyway, I will have to give today and yesterday was among the worse one-day non-realised loss that I have ever experienced (self-deprecation laugh). I am sure Warren and Charlie were not blinking how IBM and KO were doing last two days. If there is anything Buffett had once said he wanted IBM shares to stay low for a while because he wanted the buybacks to be most effective.
    Further In defence of IBM (not really a financial one) – for 9 consecutive years, IBM is in the world top 20 private companies in R&D budget (). For 2012, IBM has generated more patents than Oracle, Intel (+ others) combined (). The value of science/technology and pharmaceutical companies are not just what they are selling right now, but you have to consider what is in their development R&D pipeline.

  3. BenHanson says:

    I’d suggest reading I Cringley’s book and posts on IBM. He makes a compelling case that they’ve hollowed out the company in the name of their 20 dollar share target. The difference now seems to be that they’ve officially missed said target, so all of that financial engineering at the expense of their customers and innovation (with a few exceptions) was for naught.

    They’re losing in two of the biggest growth areas there are. They’re losing the Cloud to Amazon, Microsoft and Google. They’re working to sell mobile devices… made by Apple.

    Yes, you own a bigger chunk of the company today than you did 10 years ago if you held onto your stock, and you’d own a bigger chunk of it today if you reinvested.

    I just don’t personally think it’s a company I’d want to own any piece of, no matter what the numbers say.

  4. Seems like a great time to be buying here, i’d probably wait for the selling to stop before entering though. It’s hard to know exactly when that will be though. You mentioned GSK at the end of your article and I also have my eyes on that. It will likely be my next purchase. I just wish I had the money right now instead of early next week. Darn timing!

  5. Purewater says:

    Ahem no, MCD’s problems are not easily solvable. You stated in the past MCD’s problems are they raised the prices and customers balked.  That’s a complete misunderstanding of the issues MCD’s faces and they’re seemingly clueless how to react.

  6. scchan_2009 says:

    BenHanson If it is R&D, IBM does not lose to any to its peers; in fact by raw numbers –  IBM (and GSK) are among top of the world in R&D expenses, acquisitions, and new patents. What probably is more creditable argument is that Amazon does provide a cheap no-frill cloud service and that competes with IBM’s premium leave-it-to-us type service. Many business would save money to take the cheap option as businesses are still try to hoard and save cash. Yet Amazon is a company that has never made money, and are just creating races to the bottom (which may benefit consumers, but I am not sure it benefits in making actual money).
    There is indeed validity to the criticism to that 20 eps goal. Really companies need to learn from Unilever or Expeditors  in how to deal with those Wall Street and the City; their answers are simple – just show them the middle finger: no EPS goals, no short term guidance issued, my annual/quarterly financial report here – take it or leave it.
    Investment is a combination of vision and self-control. What may be a negative now is quite possibly short term. Future is indeed uncertain, so it is almost a religion to believe in the vision as long as there is some facts to support that. The fact as I see it is that IBM is not doing too bad (as Tim has stated) during a down cycle and is still highly active in R&D.

  7. frfrizzo381 says:

    Tim you stole my watchlist. I just purchased BP, sold Feb puts on GSK and sold Dec puts on PM when it dipped near 80 I’m just watching IBM and MCD. VIAB is another good one that has been beaten down lately and is cheap.

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