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Why Warren Buffett Keeps Buying IBM

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(Image credit: AFP/Getty Images via @daylife)

After reading about the company for 50 years without making a move and shunning the entire tech sector for the majority of his career, Warren Buffett suddenly picked up over $10 billion in shares of IBM (IBM) recently for his company, Berkshire Hathaway (BRK.A)(BRK.B). Buffett said in Nov. 2011 on NBC when he announced owning a stake in the company that “he would not be announcing it if he were not pretty much done” buying shares. But over the next three quarters he has found the stock attractive enough to continue buying, making it the second most-bought stock in his portfolio, and causing investors to ask why.

(Read about why he is buying his most-purchased stock, Wells Fargo (WFC) here.)

Purchasing History

Buffett began to buy IBM shares in the first quarter of 2011, with 4,517,774 shares for a price of $159 on average. Purchasing became more aggressive in the second and third quarter when he cumulatively bought more than 82.2 million shares for $167 and $173 on average. From the fourth quarter of 2011, to the third quarter of 2012, he made smaller purchases at average prices ranging from $185 to $197.

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By the end of the third quarter, he owned a total of 67,517,896 shares, which equals 5.98% of IBM’s shares outstanding. It also made the company an 18.6% weighting in Buffett’s portfolio.

ManagementBusiness Execution

Buffett praised IBM CEOs Lou Gerstner and Sam Palmisano in his 2011 annual letter for rescuing IBM from the brink of bankruptcy 20 years ago and making it into a successful business today. In addition to their “extraordinary” operational accomplishments, “their financial management was equally brilliant,” Buffett said, “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 consistently uses “Road Maps” to create targets for the future and measure progress in the present. Buffett was impressed that the company had met its benchmarks for a plan introduced in 2007 called the 2010 Road Map, and in 2011 proved it is on its way toward the goals set forth in the 2015 Road Map that replaced it. In 2010, the company surpassed its 2007 goal of $10 to $11 in earnings per share by reaching EPS of $11.52 in 2010.

The company’s 2015 map focuses on the major drivers of its earnings per share performance: operating leverage, share repurchases and growth strategies. Specifically, according to the company’s 10-K, highlights of the metrics it is aiming for include:

· $50 billion in share repurchases

· $20 billion in dividends

· $20 in EPS (non-GAAP)

· $100 billion in free cash flow

· $20 billion spending on acquisitions

· Software becoming about half of segment profit

· Growth priorities:

1. Growth markets unit accounting for 30 percent of segment revenue by 2015 (it was 21 percent in 2010)

2. Analytics growth to $16 billion in revenue

3. $7 billion in revenue from cloud computing

4. Smarter Planet solutions to grow to $10 billion in revenue

In 2011, the company had achieved the following progress toward its 2015 goals:

· $3.473 billion paid in dividends (9.32% increase year over year)

· $15.05 billion in share repurchases

· $13.44 in diluted operating (non-GAAP) earnings per share (a record)

· $16.6 billion in free cash flow (a record)

· $1.8 billion for five acquisitions in software

· Software and services was 44% of segment profit

· Growth Priorities:

1. Growth markets accounted for 22% of geographic revenue (an 11 increase from 2000)

2. 16% revenue growth year over year

3. 200% revenue growth year over year

4. 50% revenue growth year over year

IBM said 2011’s positive financial performance resulted from the transformation it began year ago to shift the business “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 involved in the transformation include exiting its PC and hard disk drive businesses in time for the dramatic slow-down that would take place in those industries. It also introduced new businesses like products, services, skills and technologies into the mix.

The focus on growth and investment in innovation allowed the company to enter new markets and delve into new waves in the technology sphere such as business analytics and cloud computing.

Moat

This transition has transformed the company into a service company instead of a hardware/software company. Buffett in his CNBC interview noted that companies are reluctant to change their IT suppliers and as companies around the world look for companies to develop their IT departments, they are likely to turn to a trusted and iconic name like IBM.

Business Metrics

Buffett said on CNBC that American businesses were a great place to put money currently, specifically businesses that “are earning very good money, that have high returns on equity, have high returns on incremental capital, are buying in their stock at a rapid rate so that your ownership in the business increases significantly.”

In IBM’s case, it has:

· Return on equity – In 2009, 2010 and 2011, IBM generated return on equity of 59%, 64% and 78.4%, far higher than in the earlier part of the decade.

· Stock repurchases – IBM has a strong history of repurchasing shares. Buffett said he would be happy to see IBM reduce its share count to 64 million shares. Since 2003, the company has decreased its share count annually, from 1.72 billion in 2003 to 1.179 billion in 2011.

Though future earnings primarily will determine Buffett’s success in IBM, Buffett said in his 2011 letter, he hopes the stock prices languishes because the amount of he is able to purchase with the amount of money they dedicate toward repurchases was “an important secondary factor.” The more shares it is able the buy, the greater the percentage of the company he will own.

IBM data by GuruFocus.com

Buffett bought IBM at near historical-high prices. In the past year its stock price has increased almost 6%. It has a P/E of 13.5, P/B of 10.2 and P/S of 2.

Here is the complete portfolio of Warren Buffett. Also check out:

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