Monday, April 9, 2012

Why I Own IBM

I received the hard copy of IBM’s 2011 annual report a few weeks ago but only got around to reading it today. I always enjoy reading the annual reports of companies I am already invested in. It gives me the opportunity to revise if the reasons why I bought shares are still valid, and if the company is still worthy of my investment.


I got the idea to invest in IBM (IBM:US) from Marvin Schwartz, the vice-chairman of Neuberger Berman, in the beginning of 2010. At the time I was working for a Portuguese asset management company, and I traveled, with one of my bosses and a Client, to Geneva to attend a conference set up by UBP. That was the first time I set foot in Geneva, who knew 3 or 4 months afterwards I would be moving there!

Anyway back to the story. At the conference, we listened to lots of presentations, mostly from fund managers. Usually these presentations are not very interesting because they all look the same: fund managers show you 10 to 15 slides with the structure of the company and investment process and on how they have an edge. After that you are usually shown one or two stocks the fund owns (that are working out well of course).

After 2 or 3 presentations Marvin Schwartz and Henry Ramallo take the stage, and they do something I love, they have no PowerPoint presentation. They just talk to you. When asked about his best picks, Marvin Schwartz refers to The Travelers Companies, Anadarko Petroleum and IBM. He explained why he owned each of them. The one that stroke me as obvious was IBM.

Schwartz pointed out IBM’s objective of increasing EPS to $20 by 2015. He told us that he expected IBM not only to get to $20 but to reach $21. Then he assigned a conservative multiple of 15-16 times on the EPS of $20 which meant a $300 to $320 price target for 2015. IBM traded at around $125 then, which gave you an IRR of 16.6%. Add to that a dividend yield of around 1.5% and you have an IRR of 18%.

After getting back home and doing my own research I confirmed his thesis and bought some shares.

Does the thesis still hold?

The simple answer is yes. 

In 2011, IBM's 100th birthday, the big blue posted record revenues, profit, EPS and FCF. On top of this the company returned more than $18 billion to shareholders in the form of dividends and share buybacks.

In the annual report IBM depicts their “2015 IBM Road Map”, which describes how the company manages its business and serves its shareholders in a detailed financial road map. The company sticks to its target of at least $20 of EPS in 2015. To achieve this, the company wants to grow its revenue, increase operating leverage and continue with its aggressive share repurchases program.

Share repurchases are very important for IBM’s strategy. Since 2000 the company has spent over $111 billion in buying back its stock, reducing the number of shares outstanding by one third. The company expects to spend a further $50 billion until 2015, which represents one fifth of its current market capitalization. As the number of shares outstanding decreases, your stake in the company increases. All else equal, the earnings per share increase will increase as the company buys back shares: you are reducing the denominator (number of shares) while leaving the numerator (earnings) unchanged.

I will not go into more detail as to how IBM will get to its $20 target. But to anyone interested I recommend you read the annual report. They do an excellent job at explaining this.

In an investment perspective, the IRR for the $300 to $320 price target for IBM is now 13% (dividends included). This is substantially lower than the 18% Marvin gave at his presentation because the price of IBMs stock is now at around $205.

Still a good investment?

Every day you have direct or indirect contact with IBM’s products, and I don’t see this changing anytime soon. In a way IBM is the back-office of the world.

Due in part to its huge size, IBM has become very effective at acquiring other companies and creating synergies. IBM uses its sheer size to market the products of the company it acquires in several countries where the product is still not present, increasing the revenues of its acquisition by 2 or 3 times in a relatively short period.

I assign a high probability to IBM achieving its $20 EPS milestone in 2015. Remember this is the company that in 2007 said it would earn $10 by 2010 after earning $6.06 in 2006. They achieved this by 2009, after weathering the largest recession of our generation in 2008.

This said, a low risk IRR of 13% until 2015, especially with rates this low, doesn’t seem bad. Now, if we decrease the multiple to 11-12 times the IRR drops to 4.5%, and if we push it to 18-19 times the IRR goes to 18%.

Here you have a company with stable and recurring cash flow, growing at a modest pace and buying back its stock aggressively. My central scenario yields a, low risk, 13% per year, while in a "bad" scenario you only earn 4.5%/year, which is still a positive return. If the multiple expands then you’re looking at an 18% IRR.

This is why IBM has been one of my top positions for a long time now and I am not letting go any time soon.

All Aboard!

While writing this post I checked to see if Schwartz still owns IBM and he does. Big blue now represents 8.5% of his fund and is his largest position.

Warren Buffett recently invested in IBM, now owning about 5.5% of the company. He does an excellent job describing the effects of IBM’s share repurchase program in his annual letter. I strongly recommend you read it.

My position in IBM would not change if Warren Buffet or Marvin Schwartz were not invested. However, being alongside two great investors who I greatly admire is always good.

Disclosure: Long IBM

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