It certainly was a surprise to be confronted with a morning headline containing the words “Buffett, Buy and IBM” all in the same sentence. During the first three quarters of 2011 Berkshire Hathaway acquired 64 million shares in IBM, equating to $10.7B or 5.4% of the company.

Long standing followers will note that technology companies have long been outside Buffett’s “circle of competence”. Buffett has long preferred companies selling stable products in stable industries. The high speed of change within the technology industry places greater reliance on management to innovate in order to defend a competitive position. Those who cannot innovate are destined for poor economic returns. This is not lost on IBM, which once dominated the personal computer market only to later completely exit the business.

In regards to innovation IBM are well placed, with a century’s worth of R&D under its belt, illustrating they can adapt over a long time horizon. For the last 18 years IBM has been granted more patents per year than any other company, receiving over 38,000 patents during this period. This is a direct result of approximately $5B per year invested in research, development and engineering since 1996.

Buffett commented that after reading IBM’s recent annual report, he viewed the business through a different lens. This prompted him to visit many of his Berkshire Hathaway subsidiaries to see how their IT departments functioned and why they made the decisions they had. He came away with an enhanced perception of the position IBM holds and was impressed by the “stickiness” of their customer proposition. For further insights he read IBM’s former Chairman and CEO Lou Gerstner’s book, “Who Says Elephants Can’t Dance?” about IBM’s historic turnaround for the 2nd time.

IBM does possess some characteristics of a classic Buffett buy. Their long history has allowed Buffett to read the annual reports for over 50 years and analyse their performance across a range of business cycles. In addition, Buffett has competed directly with IBM as Chairman of Mid Continent Tab Card Company over 50 years ago as well as testifying on IBM’s behalf in an antitrust case in 1980. It’s a reasonable conclusion to say Buffett has a fair idea as to what makes this business tick.

Furthermore, a key filter for a Buffett investment is finding managers who think like owners. Management appears to have the interest of shareholders at the front of their minds and is taking action to ensure increasing value, including sound capital management and transparent performance targets. Buffett was impressed by how management has been treating their stock with “reverence”.

In addition, IBM is an iconic American business boasting impressive brand recognition. Buffett, the perpetual bull of America, has invested in other classic American companies such as General Electric and Bank of America in what appears to be a strong vote of confidence in the future of America.

The Business

IBM has refocused their operations to the higher margin and higher growth industries of software and services, which contributed 83% of revenue (up from 65% in 2000). Most of the more commodity-like businesses (personal computers, disc drives and printers) have been divested. This is notable in an improving NPAT margin over time. This also highlights the need to revisit companies periodically to keep up to date with any developments.

To give clarity on the future strategic direction, IBM publish 5 year roadmaps which give quantitative benchmarks in which management performance can be measured. (For those interested, I recommend reading IBM Chairman and CEO Sam Palmisano’s recent addresses.) This is a stark contrast to shooting the performance arrow and drawing a bull’s eye around where it lands.

EPS growth is the ultimate objective with a defined target of $20 per share by 2015. IBM surpassed the previous 5 year goal of $10-11 EPS in 2010. Management has outlined 3 key drivers of EPS:

• Operating leverage – IBM aims to improve operating leverage by shifting to higher margin business and improving enterprise productivity. Management is targeting $8B in productivity improvements over 5 years, with part flowing to the bottom line and the remainder invested to improve its competitive position.
• Capital management – IBM expects to generate $100B in cash from operations over the next 5 years. With this cash they aim to return $70B to shareholders, comprising $50B in buybacks and $20B in dividends. While it is hard to model the effectiveness of future buybacks (as price paid is indeterminable) what is certain is Berkshires stake in IBM will be larger in 2015.
• Growth – Below are IBM’s 2015 Revenue Targets:
  • Cloud computing, $7B. IBM are well placed to engage themselves in the growing use of cloud computing.
  • Smarter Planet Solutions, $10B , a division which aims to provide solutions to cities, municipalities and businesses to become more efficient in their operations.
  • Business Analytics, $16B. IBM spotted an emerging trend early and built a world leading analytics business, which employs 7,800 consultants.

In addition, the growth markets of China, Brazil and India are targeted to contribute 30% of total sales, up from 21% in 2010.

Valuation

Over the 5 year view, IBM has grown profits from $10.4B to $16.2B without needing incremental equity to do so. Analysis of standard Return on Equity over the longer term provides an equally encouraging trend.

Over the preceding 10 years, cumulative NPAT of $97.4 has been exceeded by cash flow of $171.6B. This strong cash generation is a boon for IBM, as cash can be reinvested to maintain and grow the business as well as be returned to shareholders in the form of buybacks and dividends.

Over the last 10 years, IBM has paid $18.8B in dividends and repurchased $86.8B of its own shares. This has been notably beneficial to profitability as well as increasing each continuing shareholder’s stake in the business. The guidance of $50B of buybacks in the next 5 years was likely an attractive proposition for Berkshire, which will watch their ownership stake grow over time.

If we assume an average price of $300 per share, $50B will buy back 166.7m shares. If this were to occur, Berkshire’s holding in 2015 would have grown to 6.3% of the company without adding any additional capital. In addition to receiving $1B in dividends, this provides a reasonable return for a large amount of invested capital.

IBM’s size is also attractive for Berkshire. In his early days, Buffett had more ideas than capital. Now the reverse is true and this plays a huge factor in which companies Buffett can look at buying. In 2010 Berkshire had free cash flow of nearly $12B, which equates to $230m per week ($23k per minute) for which Buffett needs to find a sensible home. For an investor who likes to be reasonably concentrated, allocating such a quantum of capital takes big ideas. To put that into perspective, if Berkshires bought ARB Corp (ASX:ARP) and it doubled it would provide a gain in book value of 0.3%. Berkshire may have a reasonable “elephant gun,” however suitable big game is increasingly becoming an endangered species.

Indeed, the size of a Berkshire investment requires an extended buying period. The doom and gloom that has persisted throughout 2011 has provided a sufficient window in which Berkshire could accumulate at decent prices. During the 9 months in which Berkshire was buying, the price fluctuated within $146-$190, averaging out at $170 per share, a sliver below our assessed value of $173.

Indeed, at $170 per share, IBM is not a screaming bargain. However, it appears Buffett seized the opportunity to deploy a substantial amount of capital into a wonderful company at a fair price. Time will tell whether this will be worthwhile for Berkshire shareholders.