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International Business Machines Corporation: We Were About To Leave; Then Warren Stopped By

Summary

The Value Investing for Main Street Model Portfolio has owned IBM at a discount since 2009.

In 2011, we were about to leave the stock after the company started missing revenue targets.

Then Warren Buffett stopped by with his infamous 64 million share purchase.

Despite its oft-publicized issues, we now view IBM as a classic “buy low, hold high, sell when you die” investment.

Welcome to the sixth installment of the Value Investing for Main Street series, exclusively on Seeking Alpha.

In 2009, the Value Investing for Main Street Model Portfolio [VIMS] initiated a position in the International Business Machines Corporation (NYSE:IBM) at an average price of $113.77 that was subsequently walloped by the return of the S&P 500 Index. Following burgeoning issues such as declining revenue growth, we contemplated exiting the position in the third quarter of 2011 to take advantage of a 60% jump in the stock price from our 2009 baseline.

Then in November 2011, Warren Buffett announced his Berkshire Hathaway (NYSE:BRK.B) conglomerate had accumulated 64 million shares of the company. His decision was curious as Buffett had famously avoided technology companies. We decided to stay with IBM figuring that Warren - the master of value investing - must know something we did not.

Today, despite its stagnant stock price from widely publicized issues since Buffett's buy-in and a narrow moat encircling hard to understand products and services, we now embrace IBM as a classic "buy low, hold high, sell when you die" investment. Here's why.

From Earnings to Dividends

IBM and the IBM logo are trademarks of International Business Machines Corp.

IBM and the IBM logo are trademarks of International Business Machines Corp.

IBM is a large value stock in the IT consulting & services industry within the information technology sector. As of this writing, its market capitalization (current market price of one share of stock times total shares outstanding) was an approximate $150 billion. IBM's current price to earnings ratio, i.e., P/E or current stock price relative to earnings per share for the trailing twelve months [TTM] is in the low teens versus the low 20's for the Standard & Poor's 500 Index of the largest companies traded on U.S. stock exchanges.

Despite our skepticism in forecasting, the fiscal year forward price to earnings ratio (P/FE, or current stock price relative to one year forward forecasted earnings per share) is also in the low teens compared to just under 20 for the S&P 500. In either scenario, trailing or forward, the P/E ratios for IBM appear discounted to the market as a whole.

IBM PE Ratio [TTM] data by YCharts

IBM's most recent earnings per share, i.e., EPS or the portion of adjusted net income to each outstanding share of common stock, is a robust $12.36, due in part to recent share buybacks. As of this writing, IBM is paying a generous 45% of its EPS to shareholders in an annual dividend of $5.60, paid quarterly for a 3.60% dividend yield. These are significant numbers for a main street value investor committed to total return from a stock's capital appreciation and dividend payments.

As Long as the Clients Understand the Products...

IBM surrounds itself in a narrow moat or the subjective measurement of the competitive advantages of a company's goods or services in the overall marketplace. A wider moat creates a barrier to entry for potential competitors. Companies with narrow or no moats are typical in the crowded information technology space, although IBM's enduring legacy in the tech arena provides some degree of a competitive benefit.

Understanding a company's goods or services and competitive advantages are essential to the main street value investor. We want to own businesses whose products or services are easy to comprehend. On some levels, IBM's products and services are difficult to understand for the lay investor not in tune with the sophistication of the ever expanding global information technology infrastructure where IBM plays a significant role.

Warren Buffett has famously said that he recommends buying companies whose products or services are easily understood and he has mostly avoided technology companies as a result. He apparently made an exception with IBM or perhaps is tuned-in to the company's sophisticated offerings.

IBM is a broadly diversified international information technology consulting and services enterprise that from a marketing standpoint divides itself into two segments: products and services. However, in 2014, the company declared strategic imperatives around three main digital forces: big data and analytics, cloud, and engagement.

Since 2010, IBM has invested approximately $30 billion in these areas, built out the IBM Cloud on a global scale, established the Watson Group, announced 50 acquisitions and entered into major partnerships, including the landmark alliance with Apple to bring mobile to the enterprise. As IBM's clients transform, "digital" itself is not the destination, but a foundation to create a truly Cognitive Enterprise. This is resulting in new types of interactions between people, organizations, and machines. (Source: IBM 2015 Annual Report)

Key tenets of the company's highly differentiated strategy include:

Cognitive Solutions: Advanced analytics and key data led by Watson, IBM's foray into artificial intelligence. Watson is a supercomputer system capable of answering questions posed in natural language and was named after IBM's first CEO, the industrialist Thomas J. Watson.

Cloud Platform: New offerings are cloud-enabled with client solutions built on the IBM Cloud. The company claims to have the most secure hybrid cloud platform in the industry.

Industry Focus: Solutions built for the needs of individual industries and professions.

(Source: IBM's most recent Form 10K filed with Securities & Exchange Commission in February 2016)

As an individual investor, I find IBM's products and services as highly sophisticated to the point of confusing. This presents a challenge to the main street value investor's essential view of only buying companies whose goods or services are readily understood by the layperson. Mr. Buffett made an exception. Should we? The proof lies in the objective details of IBM's fundamentals, valuation, and risk, including any variant assessments of an ultimately subjective analysis.

Keep Sending Cash, Thank You

IBM CEO Ginni Rometty [Photo Courtesy of IBM]

When considering the worthiness of a company's inclusion in the Value Investing for Main Street Model Portfolio [VIMS], the emphasis is placed on recent actual growth metrics as opposed to speculative forecasts of what may or may not happen with revenue, earnings per share, free cash flow, or dividend growth. We look for positive, trailing five-year revenue and earnings growth, and ten years of positive increases in free cash flow and dividends. As defensive investors, we prefer companies that are already growing, not just promising to grow.

In the most recent five-year period, IBM's revenue and earnings per share growth are (3.93%) and 3.37%, demonstrating a flat long-term growth to the main street value investor. We are further discouraged by the company's negative 14.03% five-year growth in free cash flow, i.e., how much cash the business generates after accounting for capital investments such as buildings and equipment.

But IBM has a most recent ten-year compounded annual dividend growth rate of 20.4%, i.e., the year-over-year rate at which dividends would have grown on a yearly basis if they had appreciated at a steady rate over the ten-year period. To be sure, the company's overall growth is grudging along, but we like the upward trajectory of its dividend payout to shareholders.

Management and Staff are Delivering Cash to Investors

Led by Virginia M. (Ginni) Rometty, chairwoman, president, and chief executive officer, the senior executives and global employee base at International Business Machines are delivering a trailing twelve months operating margin (EBIT or earnings before interest and taxes) at a modest 16.73% of revenue. Nonetheless...


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