covenant-lite
Nov 9, 2015 · 7 min read

A Few Thoughts On Warren Buffett’s Investment In IBM

“Adults suffer now to be better off later.” — C. Munger

“In Silicon Valley, if you’re not growing, you’re dying.” — J. Chanos

“We invest in companies with ‘capacity to suffer’.” — T. Russo

  • I’ve had more than a few professional and personal discussions about Buffett’s investment in IBM. I was skeptical as a Berkshire owner.
  • The following is a few scattered thoughts on the timing and sizing of Berkshire’s investment, general thoughts, and no facts or figures on actual valuation. These are mostly speculative thoughts. I’ve not spoken to Buffett or Berkshire management to confirm or deny any of these theses. These may or may not have been the ideas behind the investment.

2011:

  1. In 2011 IBM (their French R&D office) released what they believed to be the future of the IT stack- cloud computing. It included SaaS IT replacing on-premise IT services.
  2. This included IBM’s theses on the distinctions between public, hybrid, and private clouds and how they would sell enterprise IT going forward.
  3. It became abundantly clear that IBM’s practice of stuffing their stacks with consultants and on premise IT labor along with IT outsourcing would eventually die and be replaced by “pay-as-you-go” cloud SaaS (less labor intensive, no incremental capital required, higher margin).
  4. IBM laid out their now infamous “roadmap” that would guide them through the transition through 2015. They would offer their enterprise clients a range of value propositions in the range of public, hybrid, and private clouds.
  5. Consulting, on-premise IT and the mainframe wouldn’t die completely as the replacement cost for some organizations, including governments, airlines, and financial institutions, is enormous and prohibitive. Hybrid and private cloud solutions would be required for transition.
  6. Buffett makes his investment, knowing how ingrained IBM is in his own organization and their customer captivity, costs of switching, and “brand name” (read: CIO/CTO cover your ass protection).
  7. Buffett likes the appeal of the SaaS economics and lack of asset/capital intensity. A long term investment was made in a legendary company with a history of shareholder value creation, now (finally?) entering a business with highly attractive economics (SaaS).

IBM was forced to cannibalize itself, killing the golden goose (total control over enterprise IT stacks) that had made the company so successful. Open stacks are the future. It would have to transition to the higher margin, less labor intensive cloud model. CEO and Chairman Sam Palmisano retires on Jan 1, 2012. Ginni Rometty is appointed CEO. The transition and the “roadmap” begins.

Q4 2015:

  1. IBM’s share price and top-line revenue has declined for four years in a row. The roadmap was abandoned as a multitude of headwinds (FX, lack of linux OS attach, Edward Snowden revelations relating to back doors in IBM systems, secular declines in legacy businesses) knocked IBM off the $20 operating EPS goal.
  2. Amazon Web Services has stolen any and all new cloud IT by offering a lower cost, full service public cloud solution. Microsoft has an additional suite of offerings (Azure, O365) quickly gaining market share. The economics of cloud are extremely attractive (20% operating margin at AMZN, 40% operating margin at MSFT).
  3. IBM’s new CEO is being questioned for her competency and is pushing a new era of “cognitive computing” as part of the campaign to commercialize the Watson unit. Opportunities in security, CRM, public cloud, and others have been sorely missed. Share repurchases and leverage have almost entirely recapitalized the company, now far more heavily indebted.
  4. Green shoots in strategic imperative revenue (analytics, security, cloud, and to a lesser extent mobile and social IT solutions) have grown at high teens CAGRs. Total cloud revenue run rate is up to $9.4 billion. Pretax software margins still run at >40%, R&D is steady at 6% of revenues. Parent company gross margin and EBIT margin rise to over 51% & 21% respectively. Their OpenPOWER Foundation, predicated on open source firmware and uniform server architecture across data centers, has drawn in partnerships with Google, Samsung, Rackspace, and others. Partnerships with Box in cloud storage and Apple in enterprise hardware have shown IBM’s willingness to adapt to Silicon Valley’s entrance into enterprise IT.
  5. Legacy businesses such as storage, outsourcing, consulting, and midrange server operating systems are withering on the vine. Massive layoffs plague morale and the company is struggling to hire talent away from Silicon Valley giants. Foreign exchange headwinds seem almost never ending as the dollar strengthens while 70% of IBM’s revenue continues to be in non-dollar currencies. Hedges are rolling off and it’s more expensive than ever to hedge back to USD.
  6. Rometty has tried to mend fences with Premier Xi Jinping on a recent visit to the U.S. in an effort to regain the trust of the Chinese government. The entire country will need to modernize its IT infrastructure in the coming decades. IBM wants to continue selling mainframes & related software in the country. A massive market opportunity looms large.

-Buffett made sure to announce in Berkshire’s Q3 press release that Berkshire had not soured on its IBM investment. Despite a massive unrealized tax loss and 4 years of underperformance, Buffett seems okay holding onto IBM despite the headwinds I’ve described above. Why is that?

-First and foremost, IBM hasn’t broken rule number 1, “don’t lose money”. Despite sorely missing their 2015 roadmap, IBM is still set to post $14.50 in operating EPS (vs. $20 OEPS 2011 estimate). The company has returned the cash from its legacy businesses by throwing off large dividends, and Buffett’s ownership stake has increased to around 9% from the large amount of repurchase. Secondly, despite almost $40 billion in debt IBM has a AA credit rating and continues to throw off large amounts of free cash flow while requiring no incremental capital from the capital markets, almost guaranteeing Berkshire’s stake will grow larger. It may be shrinking, but the backlog of business still exists and IBM has a large pool of profit they can reinvest in their strategic imperatives, and return to shareholders. These actions are not mutually exclusive.

-IBM has divested almost all its hardware business with an exclusive focus and retention of the “get the iron in the door” financing mainframe razor & razor blade model. The System z cycle began in 2015. Their cloud run rate is larger than Microsoft’s and they’re still ramping their strategic imperatives run rate. IBM’s ultimate success or failure is pretty simple at this point.

  • IBM has proven they have a willingness and capacity to suffer. This is impressive for such a large company dependent on a business that was sure to become obsolete in the coming transition to cloud.
  • This is all well and good, but IBM’s ultimate success will depend on their product suite, not vague philosophical intentions and theories.
  • Private and hybrid clouds are imperative- there are a fixed number of institutions and governments with IBM on-premise IT attach that by their nature will continue to require on-premise storage, IT consulting, and mainframes. These enterprises will need private clouds for their transition. Regulatory risk mitigation, government data breach (China in particular) risk mitigation, and security software are at the top of the list of IT needs.
  • Security- IBM Guardium is the enterprise standard that’s winning the most contracts. This is where I think Buffett sees the most opportunity. He’s an insurance guy, and he understands the CYA needed for these risks. Whether you’re a government or a commercial bank, outsourcing your transactional or personnel data security to IBM is the safest, most conservative course of action. This “brand name” value is what differentiates IBM in the security space.
  • SoftLayer sucks compared to Amazon Web Services for small to medium sized businesses. IBM can’t compete here. Focus R&D on analytics, security and the possible moonshot known as Watson (Watson Health is the closest to monetization in diagnostics).
  • Middleware will take its lumps but the margins are still amazing and it’s an easy transition to cloud (if they decide to go with IBM). The ultimate value-add will be using IBM’s global distribution and sales force to get mission critical SaaS into enterprises (see their partnership with Box).
  • Distribution partnerships will keep IBM’s R&D costs low, as they can partner with the best innovators in enterprise cloud like Box and pick and choose the best SaaS to sell through their distribution network. Acquiring these companies isn’t out of the question either.

Ultimately the answer to the question, “did Berkshire make a good investment?” is a resounding “no” using the past four years of price movement as evidence. Buffett couldn’t have predicted the movements in FX, or the Snowden revelations, and I think he underestimated the decay in IBM’s legacy businesses. The question “is IBM a good investment at this price?” is a far more complex one. Rometty targeted $40 billion in strategic imperative revenue for 2018. The majority of this will come from cloud. Assuming a 25% EBIT margin you’re looking at a 17x EV multiple in 2018. Not cheap, even for CAGRs in the teens. Harvesting the cash from the legacy businesses will ultimately determine whether that price is worth paying today.

I think it is an attractive investment for a number of different reasons but these are the general thought processes that I think went into Buffett’s IBM investment. It’s easy to get anchored to old IBM’s trading prices, but this is almost an entirely different company. The only questions are what the runoff value of the non-strategic imperative businesses is, the distribution value of the sales network, captivity value, and mainframe attach value. You’ll have to do your own work for that one.

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my opinions don't reflect those of my employer. none of this is investment advice.