Why Does Warren Buffett Continue To Buy IBM?

Even though he spent the last 50 years or so reading about this company without making one move in its direction, and even shunning the tech sector in its entirety throughout his entire career, Warren Buffett suddenly decided to buy over $10 billion worth of shares of IBM for his company Berkshire Hathaway.

Back in November of 2011, on NBC, Warren Buffett announced that he was about to own a stake in the company, and “he would not be announcing it if he were not pretty much done” with purchasing the shares. Over the next three quarters, he has found the stock so attractive that he continues to buy up more and more shares, and it is now the second most owned stock in his entire portfolio, and this has many investors wondering why.

Purchasing History

Mister Buffett started buying up his IBM shares during the first quarter of 2011, and at that time, he purchased 4,517,774 shares for the average price of $159 per share.This purchasing became a lot more aggressive during the second and third quarter while he accumulated another 82.2 million shares for the average costs of $167 per share and $173 per share. He even made smaller purchases during the fourth quarter of 2011, as well as the third quarter of 2012, and the average prices of those shares cost $185 per share and $197 per share.

By the end of the third quarter of 2012, he owned a total amount of shares reaching 67,517,896, which is about nearly 6% of the outstanding shares in IBM. The IBM purchases also amount to 18.6% of the entire Berkshire Hathaway portfolio.

Management – Business Execution

Buffett has nothing but high praise for Lou Gerstner and Sam Palmisano, the CEOs of IBM. It is 2011 annual letter, he talks about how the gentleman rescued IBM from the brink of distraction about 20 years ago as they were facing bankruptcy, and he mentions how they turned it into an incredibly successful business in this day and age. Notwithstanding their “extraordinary” accomplishments from an operational standpoint, “their financial management was equally brilliant,” said Buffett, “particularly in recent years as the company’s financial flexibility improved. Indeed, I can think of no major company that has had better financial management, a skill that has materially increased the gains enjoyed by IBM shareholders.”

IBM regularly uses “Road Maps” to figure out targets for the future of the company, as well as measuring the company’s progress in the present. Mister Buffett was very impressed that IBM had met all of its benchmarks for a plan that they introduced during 2007, which they called the 2010 Road Map. Then in 2011 they introduced another strategy called the 2015 Road Map, which they are well on their way to achieving their goals. During 2010, the company will surpassed the goal set in 2007 of $10-$11 gain in earnings per share. They reached an EPS of $11.52 per share during 2010.

The Road Map of put together by IBM for 2015 has some major drivers in place to boost its earnings per share, such as: growth strategies, operating leverage and share repurchases. According to IBM’s 10K, some of the specific metrics they plan to aim for are:

  • a $20 earnings-per-share (non-GAAP)
  • half of their segment profit coming from software
  • $100 billion worth of free cash flow
  • dividends in the amount of $20 billion
  • $50 billion worth of share repurchases
  • growth priorities:

 

  1. Growth markets unit making up about 30% of their segment revenue by the year 2015 (during 2010, it’s about 21%)
  2. growth in analytics to reach $16 billion in revenue
  3. their cloud computing division bringing in $7 billion worth of revenue
  4. their Smarter Planet solutions division to grow to $10 billion in revenue

During the year 2011, IBM achieved a certain amount of progress toward their goals in 2015. That progress is:

  • paying dividends in the amount of $3.473 billion (which is a year over year increase of 9.32%)
  • repurchasing shares in the amount of $15.05 billion
  • a record earning diluted operating earnings-per-share of $13.44 billion (non-GAAP)
  • a record-breaking amount of $16.6 billion in free cash flow
  • five acquisitions in software and the amount of $1.8 billion
  • 44% of their segment profit came from software and services
  • growth priorities:

 

  1. 22% of their geographic revenue comes from growth markets, which is an 11% increase from the year 2000
  2. revenue growth reached 16% year over year (growth analytics)
  3. revenue growth reaches 200% year over year (cloud computing)
  4. revenue growth reaches 50% year over year (Smarter Planet)

IBM mentions that the 2011 positive financial performance is a result of the company’s transformation, where they shift their business model “to higher value areas of the market, improving productivity and investing in opportunities to drive future growth. These changes have contributed to nine consecutive years of double-digit earnings per share growth.”

Some of the changes that IBM has made during their transformation are getting out of the hard disk drive and PC business right before there was a dramatic slowdown in the market in both of those industries. They also created some new services, products, technologies and skills that they entered into the fray.

By focusing on growth, and investing in innovation, this allowed the company to journey into new markets and test out new types of technology, such as cloud computing and business analytics.

Moat

the transition made by IBM has literally transformed this business into a service company, as opposed to the software and hardware company that they used to be. During Warren Buffett interview on CNBC, he mentions that many companies are reluctant to change their IT suppliers, and as they look around the world for companies to develop their IT departments, they will often turn to business icon and trusted company IBM.

Business Metrics

Buffett also mentions on CNBC that it’s currently a good idea to start put your money into American businesses, and specifically the businesses that “are earning very good money, that have high returns on equity, have high returns on incremental capital, or buying in their stock at a rapid rate so that your ownership in the business increases significantly.”

In the case of IBM, it has:

  • Return on equity – throughout 2009, 2010 and 2011, the ROI generated by IBM was 59%, 64% and 78.4%. This is much higher than the beginning part of the decade.
  • Stock repurchases – IBM regularly repurchases their shares, which you can see throughout history. Buffett mentioned that he would be happy if IBM reduced their share count to 64 million shares. From 2003 to 2011, IBM has lowered its share count from 1.72 billion to 1.179 billion.

Even though future earnings are going to ultimately determine Warren Buffett success with IBM, during Warren Buffett’s 2011 letter, he actually hopes that the stock price languishes because the amount of shares that he is able to purchase with the amount of money IBM dedicates toward repurchases it was “an important secondary factor.” The more shares that IBM is able to buy, the bigger percentage of the company Warren Buffett will own.

Warren Buffett purchased IBM near historical high prices. Over the past year, the stock price has risen about 6%. It’s P/E is 13.5, P/B is 10.2  and P/S is to.

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