IBM Stock Buybacks Are Not Proof The Company Is Dying

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.

Originally posted 2014-01-22 15:01:17.

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7 thoughts on “IBM Stock Buybacks Are Not Proof The Company Is Dying

  1. scchan_2009 says:

    All tech companies go through relatively long development cycles – it takes year to develop and polish the next product, and sometimes it may not do well at all (look at the fisaco Blackberry and Nintendo gotten into). Most investors now only see 1/4 to 1/4 profits and somehow demands amazing tech products that every year. That is not going to happen. Historically IBM has delivered some of the greatest tech products in 20 century, and have been in the forefront of tech R&D over many decades.
    IBM has strong balance sheets, it is capable of withstand short term headwinds. Buy backs are indeed finanical engineering, however if the company has the cash flow and asset to back it, I do not see a problem. It is not that IBM is under funding its prestigious R&D. Patience will pay off for IBM shareholders.
    Since I mentioned Blackberry and Nintendo, it is actually tell you how important to maintain strong balance sheet to counter headwinds. If you examine the balance sheet of both company, both have pile up of inventory (not surprisingly), but the catch is that 1/2 of Nintendo book value is cash equivalent, but RIM/Blackberry has only about 1/5 is cash equivalent. By total a amount of cash in hand, Nintendo has nearly 7x more cash and liquid asset than RIM. it is clear which of the two have better odds to dig out of their hole. (Disclaimer: I don't own stocks in either company; but it is clear that Nintendo is a less speculative bet than RIM for recovery)
    Cash in hand and positive cash flow are king and backstop for tech companies to keep R&D going, and IBM is cash flow king – it has maintained positive cash flow for the last 10 years even for 2008, even with all the buy backs, and even with active RD and acquisitions.
    Anyway, it wasn't just IBM has doom word casted on them. Intel as well. Mobile is killing PC and Intel, Big Blue is dying, blah blah blah. Neither Big Blue nor Intel are dying.

  2. valueguy says:

    I found this to be an interesting post because I too had invested in IBM in 2012 year and unwound my two year position for a minimal   gain after the earnings report last quarter (July 2013) after the stock rebounded to about 180. I'm a patient investor, and I'm the type of person that has bought and held positions in JNJ,WFC,BRKB in 2010 and held them since then, I don't like to sell positions.  It was after some soul searching that I sold my position, which I replaced with XOM. 
    The reason are as follows.

    1. Integrity of the results.

    I'm a reasonable person, but I don't like being lied to. The last year or so has seen IBM quarterly conference calls where they would make excuses for hardware sales falling short. Or using lower Income tax to maintain the expected earnings numbers.
    Honestly, those two things are such a miniscule part of what they are doing it's almost ridiculous to even bring it up. It's like IBM management never wants to come home with a "B" report card to show their  investor "parents"  even though despite its best effort that's all that IBM deserves that quarter. 

    The best medicine is the truth. 

    What I would have liked to here was something like this:

    "Dear owners, we are a strong company that has hit a tough spot in our desired transition to higher margin businesses like software, services, and our future growth area of data analytics (which we are building out through acquisitions). Our business in software has powered a lot the gains of IBM in the last decade and as you might have noticed that business has an 80+% operating margin. When you have a software division that has 80+% margins, it invites competition from other companies. We have kept these competitors at bay for a while with our captive business model of offering a full gamut of locally installed and maintained hardware, software and specialized services that are offered by IBM. Lately we have seen that companies are offering some aspects of what we can do on a lower margin basis. This migration has been quickened by the advent of the "cloud" which offers the opportunity to offer clients similar products at a lower margin. 

    This transition is ineveitable and we at IBM are not afraid of the margin compression that will likely result in our main business of software. We expect to be large players in the "cloud" business ourselves as our culture has always put the best options for the customer at the heart of what we want to do. We have learned from the dark days in the early 1990's that we must search for the added value in the chain, and not fight yesterdays battle. 

    We want to inform you as owners to be patient as we migrate to the next phase of the "value added" in our model. We believe it will be in integrating the raw data that is being created through this "cloud based" connected world and analyzing this data in the deep way only IBM can do. We believe this to be  a high margin business of the future, which will also be of high value to our customers. 

    In the meantime we will have earnings fluctuations that will be softened by our consistent share buyback program that will offer a reasonable return on capital as there just isn't enough investment alternatives that make sense for our strategy. Simply put, we make too much money relative to what we can redeploy into growing the business.  

    You are owners and we like to treat you as such,  please consider yourselves informed and please place your faith that the vision of IBM will be seen through.
    While we expect to have $20 EPS in 2015 we will not lose focus that our goal is to build a stronger and more resilient company of the future. If the earnings are missed, it will be due to the transition we feel very confident about. And as such, if the stock value is reduced based on short term pessimism we stand ready to buy oportunistically to increase shareholder value.
     Thank you.

    Virginia Rometty
    So instead of that we got a lot of excuses and a fear that discussing that competion is real would be a sign of failure. Why? You're IBM, everyone is always chasing you. Just admit it and move on. They seemingly are repeating mistakes of the 1990's by not acknowleding that the "cloud" fundamentally chages the overall profit margin of the software businesses. So what? When you are zipping along at an 80% profit margin business what did they expect would happen?

    I like XOM because they are a little more intellectually honest with capital allocation, strategic acqisitions and I believe that over the next couple of decades the comparable returns will be similar to IBM. They have a seemingly easier path because the tech industry is just that brutal of an arena to compete in compared to mosyt other industries. 

    Like  I said, I think an IBM investment will work out fine over time. I just felt uneasy at the lack of candor in the last few conference calls. Alex Gorski at JNJ, John Stumpf at WFC, Muhtar Kent at KO and others just had a more honest assesment of where their companies were at and were going.

    I appreciate the quality and thought of your writing Tim. Keep up the great work.

  3. scchan_2009 says:

    valueguy I think the sensitive nature of technology is one reason why Warren Buffett is scared to enter the technology business for a long time. The "technology" of pumping and refining oil is far more simple and less evolving the one with computer hardware and cloud computing. Higher volatility of profitability in tech business is somewhat a given, and IBM operates, as you say, in a tougher environment than Exxon-Mobil. IBM already probably "relatively stable" compare how fast Dell, RIM, or Nintendo fall flat on their face (in a window of 3-4 years).
    About candor and honesty, I grew up as a rather suspicious person, so I always take people talk more a grain of salt, and go check the data myself. Given the more sensitive nature of IBM business, it is harder for the folks inside the grasp what will happen in the future. One thing is that most board members and executives pay are linked with volatility of the stock price, that makes them more cautious in speaking against their own pay. Again when Romnetty said she would forfeit her bonus, … well her base pay is already so high (a couple of more zeros than my day job pay), so I took her words as bull (laugh). But I was expecting bull, so she said bull, hardly surprising (laugh).

  4. scchan_2009 says:

    I think the mobile thing caught many in tech by surprise (as we even talking about Jobs on a different article, and he being part of the devil to see this mobile thing coming). I think the slow mover can catch up if they are quick to adjust and have the cash flow and balance sheet to back the change needed. This is why I am not particular concerned about Intel – even PC sales have decline, Intel is still making money and has acknowledged some change in tech business has occurred.
    For the same above reason, why many well known stock pickers – including Buffett and Lynch – are hesitant to enter tech business (IBM is literally the first big tech position Berkshire H has taken; Berkshire only briefly owned some Intel shares). Tech business changes so fast that it is hard to see where things heading for medium or longer term. They like boring companies because their future is more certain. Tim love Coke shares, and pretty much everyone understand what Coca Cola does, and where they may be heading to. IBM has nearly been around for quite a long time relative to some his peers (Intel is less than 50 years old, and Oracle, Apple and Microsoft are like 30-some years old). I don’t even understand what some of MSFT or APPL’s younger cousins (like Google) do – mind you I don’t consider myself computer illiterate.
    I have currently 4 tech stocks in my portfolio (including IBM being my second largest position). My portfolio is suffering “diworstification”, so I contemplating selling at least 2 or even 3 of them (yes it was my mistake to buy many different stock and I don’t fully understand all of them, now I am penalised for paying my broker trading fees- laugh; making mistakes are good way to learn). However IBM is a keeper, and I have full confidence behind IBM. IBM may be boring and not fancy, but that’s the company with engineers and scientists winning multiple Nobel and Turing Prizes, the front runner company of computer mainframes and PCs, the company that showed machine can beat the best chess and Jeopardy players!

  5. scchan_2009 says:

    If one read SA tech or even general tech sites, many will claim they know things are heading (and how would that affect the fate of tech companies). I am just going to raise white flag there. The only thing I am certain is that I see a bunch of high PE or even losing money tech companies, and people got all excited about them – do Netflix or Amazon even make money? Hey people hate Intel and IBM, and those two at least have stock prices look kind of reasonable.

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