stock buybacks: the curious case of IBM

Regular readers will know that I’m not a fan of stock buybacks by companies.  I believe that even though buybacks are advertised as returning cash to shareholders in a tax-efficient way, their main effect–even if not their purpose–is to keep the dilutive effects of management stock options away from the attention of ordinary shareholders.  Admittedly, I haven’t done a study of all firms that buy back stock, but in the cases I have looked at the shares retired this way somehow end up offsetting new shares issued to management.  As a result, you and I never see the slow but steady shift in ownership away from us and toward employees.

In recent years, activist investors have made increasing stock buybacks a staple of their toolkit for “helping” stick-in-the-mud companies improve their returns.  Certainly, accelerating buybacks can give a stock an immediate price boost.  But since I don’t believe that the usual activist suspects have your or my long-term welfare as shareholders at heart, I’ve had an eye out for cases where extensive buybacks have ceased to work their magic.

I found IBM.

Actually I should put the same ” ” around found that I put around helping two paragraphs above.  I stumbled across an article late last year in, I think, the Financial Times that asserted all IBM’s earnings per share growth over the past five years came–not from operations–but from share buybacks.  A case of what Japan in the roaring 1980s called zaitech.  Hard to believe.

I’ve finally gotten around to looking.  I searched in vain for the article.  I found a relatively weak offering from the New York Times Dealbook, whose main source appears, somewhat embarrassingly for the authors, to have been IBM market-speak in its annual report.  I did find an excellent two-part series in the FT that I’d somehow missed but which appeared earlier this month.  It’s useful not only conceptually but also for IBM history.

IBM

The FT outlines the essence of the IBM plan to grow eps from $11.52  in 2010 to $20 by this year–a target abandoned last October by the new CEO..  Of the $8.50 per share advance, $3.50 was to come from revenue growth, both organic and from acquisitions; $2.50 each were to come from operating leverage–which I take to be the effect of keeping SG&A flat while revenues expanded–and share buybacks.

What actually happened from 2010 through 2014 is far different:

–IBM’s revenues, even factoring in acquisitions, fell by 7% over the five years

–2014’s operating profit was 5% higher than 2010’s

–net profit grew by 7.0%, aided by a lower tax rate,

–nevertheless, earnings per share grew by 35%!

How did this happen?

Over the five years, until share buybacks came to a screeching halt in 4Q14, IBM spent just about $70 billion on the open market on its own stock.  That’s over 3x the company’s capital expenditures over the same period.  It’s also about 3x R&D expenditure, which is probably a better indicator for a software firm.  And it’s over 3x dividend payments.

The buying reduced the share count by 315 million to 995 million shares.  The actual number of shares bought, figuring a $175 average price, would have been about 400 million.  I presume the remainder are to offset shares issued to employees exercising stock options (although there may be some acquisition stock in there–no easy way to find that out).

results?

What I find most interesting is that, other than a flurry in the first half of 2011, the huge expenditure did no good.  IBM shares have underperformed pretty consistently, despite the massive support given by the company.  And IBM has $13 billion more in debt that it had before the heavy buybacks began.

Where is the company now?

I don’t know it well enough to say for sure, but it appears to me that it has taken recent earnings disappointments to jolt IBM into the realization that the 2010 master plan hasn’t worked.  A half-decade of the corporate equivalent of liposuction and heavy makeup has not returned the firm to health.  Instead, IBM has burned up a lot of time   …and a mountain of cash.

I think it’s also reasonable to ask how ordinary IBM shareholders have benefitted from the $60+ per share “returned” to them through buybacks.  I don’t see many plusses.  The stock dropped by about $20 last October, when IBM officially gave up the 2010 plan, so some investors were fooled by the company’s zaitech.  But spending $60+ to postpone a $20 loss that happened anyway doesn’t seem like much of a deal.

Only the board of directors knows why almost five years elapsed before anyone noticed the plan had long since gone off the rails.

the Apple – IBM partnership

Jobs 1.0

Back in the early 1980s, AAPL made a better personal computer than IBM, at a time when the PC was beginning to displace the minicomputer in corporations and when individuals were starting to become a viable market for computing power.

Steve Jobs made two strategic errors, however, that ended up preventing AAPL from exploiting its advantage, which ultimately marginalized his company and put it on the verge of bankruptcy.

–AAPL priced its PC at 2x -3x the level of its MS-DOS alternatives, providing an overwhelming economic incentive to put up with the clunkiness of an IMB or a Compaq.

–Jobs marketed solely to company IT departments, which at that time had no power to make purchasing decisions.  He completely ignored the CEOs and COOs who did.  This may have enhanced his counterculture image, but it effectively closed the door to any corporate sales.

Jobs 2.0, Groundhog Day–except better so far

Arguably, Jobs 2.0 repeated the same game plan as 1.0:  make high-end, high-priced consumer devices and ignore the corporate world.  

In the post-Jobs era, and after a whole lot of waffling, AAPL management has decided to stick with Page One of the Steve playbook and is continuing to define itself as a maker of high-end consumer devices.  On the other hand, it lived (by the skin of its teeth) through Jobs 1.0 and knows how that story ended.

That’s why I think AAPL’s just-announced decision to partner with IBM to sell mobile products to corporations is potentially very significant.  It suggests AAPL is no longer willing to be straitjacketed by the Jobs mystique.  This is a good thing, because growth companies only continue to prosper if they periodically reinvent themselves.  

Also, given the continuing ineptitude of Ballmer-led Microsoft, the corporate market is much more wide open to AAPL smartphones and tablets than AAPL had any right to expect.  

I’m not rushing out to buy AAPL on the strength of a single new venture.  But it’s a start.  It suggests that Tim Cook is doing more than rearranging the deck chairs.  It argues that we should also be on the alert for further signals of favorable change in the company’s strategy.

 

 

 

 

 

Warren Buffett and IBM + Intel

Warren Buffett on TV

Warren Buffett, an iconic stock market investor, announced two days ago on television that he has acquired a 5.5% interest in IBM, now worth about $12 billion.  He apparently began accumulating the stock–the 65 million or so shares he holds amounts to about two weeks’ trading volume–in March.

why the buy is notable

The announcement is notable in a few respects–two small ones and one large.

Let’s get the small fry out of the way first:

1.  No one in his right mind goes on TV and announces he owns a ton of a given stock unless he’s finished buying.  The implicit message is “Feel free to ride on my coattails (and raise the value of my stock) if you wish.”

2.  Portfolio investors are required to disclose their holdings in a public filing (a 13-f) with the SEC each quarter.  According to Dealbook in the New York Times, a portfolio manager can request that the SEC keep secret the names of stocks the manager is continuing to buy.   (I didn’t know about this provision, despite being in the business for over a quarter-century.  Shame on me.  I bet I’m not alone, though.)  Dealbook says that’s what Buffett did in March and the SEC said okay

Now the BIG one:

3.  The purchase represents Buffett’s first significant foray into the technology industry, a place he had previously shunned for lack of little investment appeal.  His explanation for the about-face?  …the world has changed, so he’s changing with it.

Actually, though, I don’t think IBM shows that he’s changed that much.  Buffett has also acquired a relatively small stake in INTC, which I think IS an eye-opener.  He isn’t trying to keep that one out of his 13-f filings, however.  I think this means one of his assistants really wanted to buy it and Buffett is simply watching to see how the stock turns out.  So I think it’s more a test of the assistant than a vote of confidence in INTC.

Buffett as icon

Buffett has an important place in portfolio investment history.  It comes from his being the first, a half-century ago, to understand the implications of an accounting paradox.

Long before anyone else, he realized that continuous spending on advertising to establish a brand name had an enduring positive value, even though this activity appeared in the firm’s financial statements only as a negative–as expense.  (Pick a consumer-oriented company and look at the advertising expense.  It’s mind-bogglingly high today–and it used to be a lot higher.)  Similarly, developing a strong distribution network of competent sales and delivery people also has an enduring value, even though the only reflection of this in financial statements is in (higher than normal) salary expense.

Together, a strong brand name and a top-notch distribution system form a powerful–if invisible–barrier to competitors entering a market.  They also offer the opportunity for operating leverage if the firm can push a wider variety of branded products through its network.

So while his Graham and Dodd competitors were looking for nameless/faceless companies that were piling up lots of working capital and had tons of plant and equipment, Buffett was snapping up branded firms that served recurring needs in service areas like newspapers and insurance, and strong brands like Coca-Cola…at bargain basement prices.  Geico is probably his most famous current holding.

As everyone knows, he made a fortune, both for himself and for his clients.

my (more or less random) thoughts

IBM has a powerful brand name and distribution network.  The industry it operates in aside, the purchase looks to me like vintage Buffett.

I don’t think the Buffett magic works as well as it once did, for two reasons:

–once the investment industry became aware of Buffett’s superior results, everyone studied his methods carefully and began to imitate them.  By the time I entered the business in the late 1970s the value of intangibles and of service firms was already beginning to become conventional wisdom. So Buffett’s edge gradually disappeared.

–the internet happened.  Getting distribution no longer requires years of heavy advertising expenditure; it takes good public relations and web design.

Buffett has transformed himself, consciously or not, into his own brand name.  For the performance of Berkshire Hathaway stock, the mystique of the “Sage of Omaha” is at least as important as perceived investment results.

Why IBM and not AAPL?

To my mind, INTC is the much more uncharacteristic purchase.  It’s still very cheap, I think (remember, I own the stock).  But it’s a capital intensive, research and development dependent, manufacturer of (arguably) business cycle sensitive, high-priced stuff.  It faces substantial competition from ARMH.  In other words, it’s just about everything Buffett has not wanted in a company.