Looking at IBM Through Buffett's Eyes
Board: Berkshire Hathaway
As is so often the case with Buffett investment decisions, maybe we are way, way overthinking this. Maybe he just put together the pieces of what was happening around him, at Berkshire’s disparate subsidiaries, and saw a mosaic taking shape. Maybe he didn’t really have to have profound insights into complex tech directions. He just had to listen to pitches that were coming to him from his own managers, and look at the economics of their decisions.
Remember decades ago when he listened to his managers about how they were opting to pay premium, highly marked-up prices to Pinkerton rather than continuing to use their own minimum wage security people? That particular outsourcing case made sense to his business managers, but here was Pinkerton – at the time the dominant quality provider - charging and getting out-size margins from him. He read the cues and bought the whole company.
Before we go further, let’s take a moment and listen to two IBM endorsement spots by an IT exec at BNSF:
This BNSF exec also participated on an IBM client customer conference call to which supposedly about 1,000 IBM clients listened in. BNSF has been characterized as a ‘living laboratory’ for IBM. Perhaps not coincidentally, just over a decade ago BNSF outsourced a substantial portion of its IT operations to IBM. IBM offered jobs to over a hundred of BNSF’s IT staffers to stay on site at BNSF, as IBM employees. That initial 10-year contract was set to expire just around the time that Buffett started acquiring IBM stock. Maybe that was when IBM came more prominently onto Buffett’s radar.
Back around the time of the BNSF conversion, American Express also announced that it had contracted with IBM Global Services to manage many of its own IT functions. IBM offered employment to 2,000 Amex IT staffers, to stay on site as IBM employees after the switch.
In 2008 MidAmerican selected IBM as its provider for data management and archiving, and credited IBM – specifically IBM’s Data Growth Solutions - with enabling MidAmerican to integrate customer records smoothly through its several large acquisitions, merging hundreds of thousands of customer records and histories for MidAmerican. http://www-01.ibm.com/software/success/cssdb.nsf/CS/LWIS-7D9...
Back in 2002 Walmart issued an edict that all of its suppliers, regardless of size, would have to have systems capabilities that were compatible with its own IBM-partnered web-based inventory management system. It recommended all non-compliant suppliers contact IBM for help. Back sometime around then, Fruit of the Loom installed IBM’s Informix Inventory Systems, and is still using it.
Both McLane’s and Netjets elected to go with IBM’s WebSphere offering when it became available a few years ago, and again, this was just prior to Buffett’s IBM purchase.
Who knows what other IBM offerings Berkshire’s various subs have committed to, and for what duration? Maybe, like Pinkerton, Buffett just looked at what services his managers were eagerly buying, calculated the mark-up that this provider was commanding (and getting ), extrapolated that out from not only Berkshire subs, but some of their industry competitors, and decided that he might as well be on the receiving end of those markups.
And just how hefty are those markups?
IBM embarked on this ‘services’ shift just over a decade ago (discussed in their 2002 annual report). By 2003 IBM’s revenue was $89B, about 35% of which was hardware related. For the recent trailing twelve months, ten years later, revenue was only just over $100B. 14% of TTM revenue was hardware.
TTM gross margins, however, were almost 50%, compared to 37% in 2003. Net profit margins (after tax) for the recent TTM were an impressive 17%, up from 8.5% in 2003. Translating that into dollars, net income was more than double ($16B now, vs $7.6B back then). Looking at it from another perspective, almost the entire revenue increase over the decade, paltry as it may have seemed overall, flowed through to the bottom line. That’s an impressive deceleration and redirection of a business.
With IBM’s share buybacks over the decade, outstanding shares were reduced from 1.7B to 1.1B. As a result, earnings per share are up from $4.32 to over $14 now. Dividends are up from $0.63 to $3.60 per share; by comparison the stock price has approximately doubled.
But back to those markups. Let’s apply Charlie’s ‘always invert’ (and I’m going to take some license and over-simplify a bit). In a largely service business, 50% gross margins mean that overall, IBM is marking up service employees billings to about double their actual salaries. To the extent that Berkshire subs (and similar customers) are willing to pay this, they are apparently recognizing a hefty value-add for IBM’s services.
When we see press releases of company decisions to go with IBM for services, we also often see that the reporting company also considered Accenture. Arch-rival Accenture, however, is realizing gross margins of 30%. Accenture (formerly Andersen Consulting, Arthur Andersen’s consulting spin-off) apparently can only manage to mark up salaries by 45 cents per consultant payroll dollar, versus IBM’s $1 per consulting payroll dollar. (I’m assuming Accenture manages their staff’s time about as well as IBM does, meaning their percentage of consultants’ time that is billable is at competitive levels).
In any case, that billing premium is an impressive value add for IBM. Now I’m taking some liberties here – IBM is not pure services – it is saddled with that 14% segment of lower-margin hardware, but they are also probably helped by their strong software mix. But then again, as with IBM’s businesses with Berkshire, their proprietary software offering and related service are probably highly entwined. I’d argue that it’s ok to look at that company total.
In any case, IBM (which, by the way includes its PriceWaterhouseConsulting business, which has always gone head-to-head with Accenture) has a higher perceived value-add in its billed dollar. Its customers are willing to pay a nice premium for IBM.
Again, we might guess that Buffett is probably hearing pretty specific feedback regarding IBM from the various far-flung corners of the Berkshire empire – and considering that he has some idea of Berkshire’s total corporate tab with IBM, and by extension, just how much his businesses alone are funding IBM’s bottom line, and what might be in Berkshire's IBM 'wish-list' pipeline – he can come to as an informed decision about IBM’s potential as anyone. And maybe that includes the many tech-knowledgeable pundits who are now wondering what he possibly could be thinking.