Warren Buffett’s $IBM down 10% for the week as first quarter misses $BRK.B

Warren Buffett’s 18% holding IBM misses first quarter earnings amid rumors of restructuring and weak sales.

I didn’t hear this news on any of my news sources but this morning I realize from a technical analysis  blog that IBM, a DOW component was down 10% for the week.

For a very well trending stock this has come as a surprise, which probably explains the fall.

This 10% drop is probably the biggest drop in 8 years. Quite particular we are starting to see much of this sudden shock a period of relatively low volatility.

A weak first quarter

The weak results are attributable to a weak software and server segment.

On top of that, the company said that they were hurt by belt tightening initiatives in China corporate sector and sales teams failing to close the deals by the end of the quarter.

1. Diluted EPS
   1. Gaap: $2.7 (up 3%)
   2. Operating (non GAAP): $3.0 (up 8%)
2. Net Income
   1. GAAP: $3.0 billion, (down 1%)
   2. Operating (non GAAP): $3.4 billion ( up 3%)
3. Gross Profit Margin
   1. GAAP: 45% (up 0.6%)
   2. Operating (non GAAP): 46.7% (up 1%)
4. FCF of 1.7 billion  down 0.2 billion
5. Software revenue flat, pre-tax income up 4%
6. Services revenue down 4%, pre-tax income up 10%, margin up 2%
7. Systems and technology revenue down 17%
8. Global markets revenue down 1%
9. Business analytics revenue up 7%
10. Smarter planet revenue up 25%
11. Cloud revenue up 70%

They are expecting the full year 2013 operating EPS to be at least $16.70

At current share price of $190. This gives it a forward PE of 11 times, which looks damn cheap.

Invert that, and the earnings yield comes to 9%.

The amazing thing is that with a operating EPS of $3 this quarter, they dare to forecast a full year $16 EPS. This means really that they failed to close much deals and that next quarter it will be good.

They have a total of 24 billion in long term debt and 8 billion short term debt and 10 billion in cash.

Net debt to Asset is 22/117 = 18%

Forecasted ROE: 18.5/19 = 98% (!!!)

Forecasted ROA: 18.5 / 117 = 15%

Forecasted ROIC: 18.5 (117-10 (cash)-34 (net current liabilities)) = 25%

Why are the figures so high? That is usually the hallmark of lean services software companies.

Using Price to book probably doesn’t make sense since  due to the high ROE the the PTB shows a certain level of premium.

Based on these data, it looks like we have a good value proposition.

Warren Buffett’s Purchases

After 50 years of not owning the stock because he probably don’t understand it, Mr Buffett finally made the purchase in 2011.

Probably because he has no choice but to deploy cash.

In total, he held 5.98% of IBM shares, which is 18% of Berkshire Hathaway’s portfolio.

 

Buffett probably see IBM as an 8% equity bond

The difference between a bond and a stock is that bond coupons are much more predictable.

In contrast, your equity returns garnered from dividends, share buy backs may fluctuate, depending on how well that business does.

The whole game changes when you can have a methodology to find a business that will be stable and growing its free cash flow consistently over 20 years.

In the long run, free cash flow will equal to net income.

That scenario Buffett sees IBM as

1. The people in IBM are great capital allocators.
   1. They issue debt and buy back debt well
   2. They deploy the capital in worthy and future valuable assets
   3. They know when  to do share repurchases and issue dividends
2. A business that has an economic moat that can continue for 20 years at least
3. Managed by a management culture (read this) that is self renewing and self correcting
4. As IBM is a company that forecast their technological plan as well as what they intend to to for their share holders. Their plan for 2015 is as follows
   1. 50 billion in share repurchases
   2. 20 billion in dividends
   3. 20 in EPS
   4. 100 billion in free cash flow
   5. 20 billion  on acquisitions
   6. growth markets units to account for 30% of revenue by 2015
   7. analytics to grow to 16 billion in revenue
   8. 7 billion revenue from cloud computing
   9. Smarter Planet solutions  to grow to 10 bil in revenue
5. There is a predictable growth in this equity

At a PE of 12 times, this gives it an earnings yield of 8%. To him it is probably a “safe” bond because

• good allocators
• iconic brand name
• economic moat

The good thing for international investors is that, there is a 30% withholding tax on dividends in the United States. And so if you are able to gain most of your earnings from a rising stock price, that looks a good deal.

Buffett doesn’t want IBM share price to go up

It may surprise many investors, but when Buffett makes his large allocation to IBM, he said that he doesn’t want the share price to go up.

Why would an investor think that?

Only reason when the management thinks the business is valuable versus the current stock price and wants to add  shareholder value by buying back shares.

Remember we said on top that the plan to 2015 is to use 50 billion to purchase shares.

If you are a shareholder, would you want to purchase the shares cheap or expensive?

If IBM’s stock price averages, say, $200 during the[next five years], the company will acquire 250 million shares for its $50 billion. There would consequently be 910 million shares outstanding, and we would own about 7% of the company. If the stock conversely sells for an average of $300 during the five-year period, IBM will acquire only 167 million shares. That would leave about 990 million shares outstanding after five years, of which we would own 6.5%.

If IBM were to earn, say, $20 billion in the fifth year, our share of those earnings would be a full $100 million greater under the disappointing scenario of a lower stock price than they would have been at the higher price. At some later point our shares would be worth perhaps $1-1/2 billion more than if the high-price repurchase scenario had taken place.

The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon.

– Buffett

IBM may sell their server division

For a business that makes more money than other company selling servers, saying they want to sell their server division indicates a bleak future for it.

This past fall, Intel’s Diane Bryant told us that 75 percent of the company’s server chip revenue now companies from eight different companies — and that one of them is Google, which designs its own servers. Four years ago, that 75 percent rested solely with Dell, HP, and IBM. – Wired.com

In the technology world today the movement to cloud have abstract away the hardware layer and the main bulk of the buyer of physical hardware servers based around the x86 architecture have been data centers.

The obnoxious trend is that Amazon, Facebook and Google, which host a lot of datacenters, are designing their own hardware, so that it performs better with their services, and also to reduce cost.

In this scenario, the servers may not be a good business going forward.

This looks so similar to their decision in 2005 to sell off their PC division to Lenovo, whom they are looking to sell to.

Are they that good of an evaluators?

Its hard to know, but as a tech geek, I tend to agree with the rational to sell it.

Summary

Is IBM a buy?

At a price of $190 it does look very enticing.

But there are dark clouds ahead.

For one, Sam Palmisano did a great job from 2002 to last year changing IBM. He just step down not too long ago.

There are a specter of  a questionable board of directors pushing out an old CEO until a certain age.

There are question mark whether the new IBM CEO Ginni Rometty is able to allocate capital as well as her predecessor.

Buffett have said he would be willing to make more purchases at the price of 167-170 region, which is 10% below current price.

In my opinion we can watch how Buffett changes his holdings. We know that Buffett place a high emphasis on good capital allocators for the role of a company CEO.

If he smells that Ms Rometty is not a good one or that the board is behaving like how HP is destroying the company, he would have opt to reduce his holdings.

The future of computing and related services may not be very clear. For that a huge bet is really on the management knowing the industry better than us.

The key metrics of monitoring is that free cash flow should be prove of justification of good execution.

I am attracted to this stock as an investment opportunity. But somehow this CEO avoiding explaining this poor quarter makes me think whether she got the factor to steer IBM well.

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