Munger on IBM: Thank God We Got A Good Price

In 1999, IBM sold $82.5 billion worth of tech stuff around the world. This year, it is going to sell $82.5 billion worth of tech stuff around the world. The revenue peaked to $101 billion in 2011, and has come down rapidly as cheap cloud storage solutions have found a place in the heart of corporate America over hardware with ongoing maintenance courtesy of IBM.

And yet, the profits generated over that time period has increased by quite a lot over this sixteen-year time period. IBM made $6 billion in net profits back in 1999, and it makes over $14 billion in net profit now. The earnings per share growth has been much better over the past sixteen years, climbing from $3.72 in 1999 to $14.25 now. It’s hard to ask for much more than an investment that quadruples earnings over a sixteen-year stretch.

At the most recent annual meeting, Munger got asked whether IBM faced a permanent downward trend in which competitors would eat into its market share. Munger responded that IBM is an enormous company with vast resources, the mixed bag of hardware performance meant difficulty growing revenues ahead, and it was tremendously important that Berkshire Hathaway paid a reasonable price to establish ownership position in the stock.

That makes sense. If you overpay and purchase Nike stock right now at 30x earnings, you are still going to be in a much better position than someone that pays 30x earnings to buy a water utility. The core economic engine of Nike delivers better sales growth, and this translates into a higher earnings per share growth rate that can soften the blow when the valuation reverts to the 20x earnings range.

IBM once again catches my attention now that the price of the stock has fallen to $137 per share in today’s late afternoon trading. The decline in IBM’s price was due to: (1) another quarterly revenue decline; (2) disappointing results from the Global Business Services; and (3) the acknowledgement that the SEC is investigating revenue recognition regarding transactions in the United States, United Kingdom, and Ireland.

This trifecta of bad news has put IBM in the place of being the cheapest it has been in the past quarter century. The stock did not get this cheap during the financial crisis. At a price of $137 compared to $14.25 in current earnings, the earnings yield is 10.4%. That means, theoretically, if IBM never grew or invested in another initiative, it could pay out 10.4% annual dividends to shareholders into perpetuity.

Although the business wouldn’t do this, it is a worthwhile construct for considering how low the expectations are for this tech giant, and consequently, how strong the current valuation foundation is for satisfactory long-term returns.

When people point to that Ibottson data which shows the United States stock market generated nearly 10% annual returns between 1926 and 2013, they are demonstrating the following: 10% returns on a pre-tax basis are achieved through 3.5% dividends and 6.5% and the assumption of a long-term P/E ratio of 15. On this current news, IBM offers a dividend of 3.7% and a P/E ratio of 9.6. Because of the valuation has gotten so cheap, IBM would only need to generate 3.5% long-term earnings growth to deliver long-term returns that are equal to the S&P 500 as a whole.

And today, IBM announced that it was expanding its buyback program by $4 billion, giving the company a total current authorization of $6.4 billion. It is on pace to retire almost 5% of its outstanding stock in the next twelve months.

Although it has become an uncomfortable investment for some, it has nevertheless become an example of stacking the long-term odds in your favor. You get a 3.77% dividend yield. You get 5% earnings per share growth rate from the buyback alone. You get a P/E ratio of 9.61 that ought to drift towards 15 in the long run (once revenue growth returns.) That’s a 56% increase in valuation. And none of this factors in the potential for actual net profit growth. Just because it has not been around for the past three years does not mean that it will not return again.

It is always the case that attractive valuations in the stock market will be accompanied by things going wrong. I remember when I first started writing about General Electric. It was in the teens. People were criticizing the leadership at GE, the dividend cut during the financial crisis, and the sluggish performance immediately coming out of the recession. Now, the industrial division has delivered some growth and articulated a clear platform for future growth, the financial assets are being shed, and the price is near $30.

The Buffett quote on this topic is that “you pay a dear price for a cheery consensus.” Waiting for people to like GE again took away the opportunity to get a good deal on the stock.

If you want to make money in energy, you have to do things like buy Royal Dutch Shell at $52 per share when the price of oil is in the $40s. If you wait for it to signal a rise, the opportunity will be gone. If you want to make money in retail, you should buy Wal-Mart during generally good times when people are trading up and it is not rolling out many new stores in the particular year. You got to buy it now at $57, rather than wait for a series of good news.

And the same thing is true for IBM. While analysts are considered about revenues and the transition from a hardware-focused corporate world to a cloud-focused corporate world, the opportunity to get a good deal on the stock exists in conjunction with the uncertainty. The dividend yield is 3.7%. The P/E ratio is a bit over 9. The earnings per share is being increased 5% due to the buyback. There is $14 billion in annual profits being generated this year. Those are the elements that come together to make IBM have an attractive valuation, and the current hurdle is set so low that even modest news will deliver above-average gains for shareholders that stick with it.