The elephant is wobbling, even as some expect it to dance. Among the admirers is Warren Buffett, which makes IBM an interesting study. Its among his top 4 holdings, worth more than $10 billion. He started buying in 2011 & bought more in late 2015.
What makes Buffett’s choice of IBM interesting is it seems to go against some of his basic tenets. IBM carries huge debt. A massive $40 billion debt on just $14.4 billion equity. It is also in the midst of a turnaround, trying to increase revenue from new high-growth, high-margin businesses and divesting slow-growth, low-margin businesses. Simultaneously, it shows a high >90% return on equity, significant free cash flow of $13 billion, both consistent over the last many years.
Huge debt of this size can kill companies. Also IBM may not need such debt to grow its business, as it generates significant cash from existing operations. Part of the debt has possibly funded dividends & its massive share buyback program over last few years. Both revenues & net profit have dropped over last 5 years. But operating EPS has grown, largely because of the share buybacks.
The business turnaround has shown progress, but its not done yet. IBM’s so called strategic imperatives (high value businesses) has grown to contribute 35% of total revenue. These businesses – cloud, analytics, mobile, social & security – are new, fast changing & prone to disruption by new upstarts, besides competition from the likes of Amazon, Oracle, Accenture etc. As Buffett himself has said before, turnarounds seldom turn, even with great management. This cannot be a sure bet.
An optimistic scenario would be IBM executing well on both its ongoing debt & earnings management, and the turnaround. A pragmatic scenario is a long, uncertain & difficult turnaround, slowing or flat revenues & profits, and debt pay downs using the cash flows.
In the meantime, IBM’s handsome dividends & growing EPS could possibly reverse the drop in stock price. Its fallen from about $170 per share when Buffett started buying in 2011 to about $122 now. Some find it attractive due to its significant cash flows, ability to remain profitable, and strong brand & IP, despite huge debt.
We have a modern Titanic, sailing on unchartered waters, executing a turn-around, with some interesting passengers on board. Will the ship come home?