Ignore Warren Buffett, Give International Business Machines Corp. (IBM) Stock a Chance

CNBC’s Becky Quick caught up with Warren Buffett before this past May’s Berkshire Hathaway Inc. (NYSE:BRK.A,NYSE:BRK.B) annual meeting in Omaha, Nebraska, to ask him about International Business Machines Corp. (NYSE:IBM) and his decision to sell about one-third of his company’s 81 million shares of IBM stock.

Ignore Warren Buffett, Give International Business Machines Corp. (IBM) Stock a Chance
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His answer put a little scare into would-be investors of IBM stock and it’s yet to recover.

“I don’t value IBM the same way that I did 6 years ago when I started buying … I’ve revalued it somewhat downward,” Buffett told CNBC. “When it got above $180, we actually sold a reasonable amount of stock.”

Consider this: Buffett sold approximately 27 million IBM stock shares in the first five months of the year. IBM’s current short interest of 20.3 million shares takes six days to cover. Buffett disposed of a stake 30% larger than the current short interest starting at $180 down to the low $160s.

It’s conceivable that Buffett’s actions have inflicted most of the damage on IBM stock so far in 2017. Other than the ongoing revenue reduction, there’s been little else in the way of IBM news to suggest the company is on the verge of collapse.

The Glass Is Half Full

InvestorPlace’s Ian Bezek sees the glass half full and so do I. His rationale rests on Watson and artificial intelligence, blockchain and bitcoin, and the cloud — all potentially lucrative to IBM’s top and bottom lines.

However (and Bezek mentions this in his article), we all know IBM’s failure to produce evidence of either revenue or income growth in recent quarters and that, more than anything, has investors rightfully suspicious.

I quickly went through the company’s second quarter 2017 10-Q and, except for its Cognitive Solutions segment (which includes Watson), every one of its other segments had lower pre-tax income margins for the three months ended June 30.

Cognitive solutions’ Q2 2017 external revenue of $4.6 billion was approximately $116 million lower than in the same period a year earlier and represents just 24% of its overall external revenue.

Its Technology Services & Cloud Platforms segment, which accounted for 44% of its overall revenue in the second quarter, saw pre-tax income margins shrink by 240 basis points.

So, yes, an investment in IBM stock right now requires an ample dose of faith. To skeptics, the glass is not half full.

Here’s Why I See It Differently

The first thing I do when looking at a beaten-down stock is go back and look at a company’s best years over a 10-year period. It gives you perspective on what the company was doing right compared to today.

In the case of IBM, its best year in terms of revenue over the past decade was 2011 when it generated $106.9 billion. Its best year as far as operating profits go was 2012, when it generated $21.1 billion.

In the trailing 12 months ended June 30, IBM’s revenue and operating profits were $78.4 billion and $12.5 billion respectively. That’s 27% less revenue and 41% less operating profits.

Not good, right? That’s true if you’re looking at these numbers in a vacuum. But, of course, we’re not. What we’re looking at is a company with $78 billion in annual revenue and operating profits of almost $13 billion.

IBM is still a rather substantial business.

Free Cash Flow is Key

The IBM stock dividend currently yields 4.1%. Income investors are likely fully aware of this. In the trailing 12 months, IBM paid out approximately $5.4 billion in dividends. That’s 46% of its $11.7 billion in free cash flow leaving it with 54% to pay down debt, invest in its business, repurchase shares and make acquisitions.

Financially, it’s got a long way to self-destruct before investors need to be remotely concerned about their dividend income.

Now, consider its free cash flow generation as a percentage of both sales and net income. According to Morningstar, it’s 1.02 times net income and 14.86% of sales. Over at Apple Inc. (NASDAQ:AAPL), generally thought to be the S&P 500 leader when it comes to free cash flow, its $51.2 billion in free cash flow for the trailing 12 months is 1.1 times net income and 22.9% of sales.

So, IBM’s free cash flow generation relative to net income isn’t that much different than Apple’s. Yet, IBM has a cash return — (free cash flow plus interest expense) / enterprise value — of 7.2%, 90 basis points higher than the cash flow king.

Bottom Line on IBM Stock

There’s a temptation to look at the paragraph above and say to yourself, “You know what, I’ll give up the 90 basis points to own a company that’s growing revenues and net income.”

That’s flawed thinking, because, in the case of IBM, although its free cash flow is about 22% less today than in 2011 and 2012, that’s still lower than the drop in revenue and operating profits over the same period.

Under challenging circumstances, IBM’s managed to run a very tight ship — and that’s probably not reflected in its current share price.

As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.

Article printed from InvestorPlace Media, https://investorplace.com/2017/10/ignore-warren-buffett-international-business-machines-corp-ibm-stock/.

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