Why Warren Buffett Loves This Company?

By Adnan Khan - January 17, 2013 | Tickers: BRK-B, IBM | 0 Comments

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In the 90’s IBM was set to fail and it seemed highly likely that it would soon be sent to the scrap yard. The way Lou Gerstner revived IBM from the brink of extinction is a management miracle and the rest is history. Gerstner’s book, ‘Who Says Elephants Can’t Dance’ is a must read for any long term IBM investor or student of management.

It is common knowledge that Warren Buffett doesn’t prefer technology stocks and still refuses to invest in Apple. The Value King’s biggest technology bet to-date remains IBM. Berkshire Hathaway (NYSE: BRK-B) announced in late 2011, that it has acquired a 5.4% stake in IBM. The fund has only increased its stake since then and currently owns a 5.9% stake in IBM. My analysis below shows that IBM is the safest bet on the technology block. It offers the investors, dividends and attractive appreciation.

International Business Machines (NYSE: IBM)

IBM is one of the world’s largest companies, with a market capitalization in excess of $200 billion. It provides technology related products and services, primarily to a global enterprise clientele. IBM is one of the world’s best examples of excellent management and growth diversification, after maturing of core businesses.

Right now it has the following five core business segments:

1-Global Technology Services

2-Software

3-Global Business Services

4-System and Technology

5-Global Financing

The Global Technology Services is IBM’s largest segment by revenue contribution at 40%, followed by Software at 23%, Global Business Services at 18%, and System and Technology at 16%. Over the last few quarters, the software segment has been showing significant improvement in profitability.

Due to its focus on enterprise clients and a global consumer base, IBM is highly affected by the global macro-economic environment. The recent economic upheavals have affected both large and small business. The adverse effect was reflected in the most recent quarterly results of IBM.

There was a decline in revenues from most segments but due to improving mix and operational efficiency, the effect on bottom-line was limited. The decline in software segment was the smallest at 1%, but there was an approximately 6% increase in segment’s income. Revenue decline was more significant in the Global Technology Services segment, as its revenues dell by 4% QoQ. However the most affected segment remained Systems and Technology, which declined by 13%.

Fundamentals

IBM’s fundamentals are impressive to say the least. As the graph below shows, over the last five years the company has maintained a solid cash balance; it currently stands at $11 billon. Despite the company’s vulnerability to macro-economic conditions, the revenues and EPS have been showing consistent improvement over the last five years. The increased focus on Cloud and new innovative segments, such as the ‘Smart planet’ initiatives, have diversified away the impact of global economic slowdown.

IBM data by YCharts

Valuations

IBM is currently trading at forward P/E of 11.7x i.e. 35% average NYSE P/e. The sell side has a mean target price of $223, which is a 15% upside at current levels. The stock also offers a forward annual dividend yield of 1.8% which is 5% above 10-year rate (1.7%). 

The table below compares IBM, to similar technology sector companies. IBM’s forward P/E ratio is the highest but its PEG ratio is pretty similar to its competitors. The table shows that at these levels Apple has the most attractive valuations with the lowest PEG ratio. Analysts are also speculating that the world’s largest company (in terms of market capitalization) will increase its dividend this quarter.

IBM directly competes with enterprise business of HP and Cisco. HP’s valuations are the worst but they are reflecting the bad market sentiment due to the Autonomy crisis, falling PC and printer sales. At these levels HP is another good tech bet but the risks are much higher as compared to IBM because there is still uncertainty surrounding the revival of HP’s PC segment. HP is betting on Windows 8 to jump start PC sales and has released some interesting products, especially Ultra-Books.

Table 1: Valuation Comparison

Headwinds

As I have mentioned above, a key concern for IBM investors should be the global economy. The business model of IBM makes it highly dependent on macro-economic issues. In this global diversification lies another major problem for IBM, the company faces the issues of a strengthening dollar. As it is ‘importing’ a major part of its total revenues, the rising dollar plays a major role in depreciating its reported revenues. Last quarter, these currency fluctuations reduced IBM revenues, by a mammoth 3%. 

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