ibm watson

 

(Source: Newsweek, via Bloomberg)

Remember when IBM built that stupid computer and then it kicked Ken Jennings’ ass? That was fun, I guess. (Aside: follow Jennings on Twitter. He’s worth your time.)

If you’ve been around here for the last few months, you’ve probably noticed that I’m not the least bit funny. Oh, and that I bash Coca-Cola a lot.

It has nothing to do with the product. I do enjoy me some Coke and some Coke Zero and even the Diet Coke because even though I know it doesn’t matter I still try and refrain from getting too pudgy by doing silly things like substituting in Diet Coke. I also enjoy some strange Korean energy drink that’s also made by the company. So I’m still doing my best to support Coca-Cola and my dentist.

No, my reasons for bashing the company have to do with the stock. Essentially, I think there’s three things wrong with it, from an investing perspective:

  1. Investors overvalue it because it’s one of the largest companies in the world, and because they heart themselves a nice, tall, frosty Coke product.
  2. It’s expensive for a company with pretty much no growth, coming in at more than 20x earnings.
  3. Executives are buying back all sorts of shares, but are issuing them almost as fast as they buy them back. I crunched the numbers a few weeks ago. It wasn’t pretty. Essentially, after factoring in share-based compensation, Coca-Cola paid a little more than $60 per share for it’s own stock. Shares have never traded above $43.

Still, dividend investors love the stock. I’m pretty sure that if you don’t invest in Coca-Cola, you’re kicked out of the dividend growth investing club. Bulls see past the three objections, and note that Coca-Cola has a strong brand, an ever rising dividend, and Warren Buffett holds a whole bunch of it, so it must be good.

Speaking of Buffett, I was reading his 2013 Chairman’s Letter online, and noticed that he’s got a huge amount of IBM stock. It’s one of Berkshire’s top five holdings, at a little over $11.6 billion cost. It’s currently worth a little less than $13 billion. Buffett owns 68 million shares, or 6.3% of the company. He paid a little over $171 per share, or about 10% less than the company’s share price today.

At the time, it was shocking behavior for Buffett. He’s always avoided technology, claiming he didn’t understand it. So why IBM?

Here’s how he justified it (from CNBC):

And if you think about it, I don’t want to push the analogy too far because it could be pushed too far. But, you know, we work with a given auditor, we work with a given law firm. That doesn’t mean we’re happy every minute of every day about everything they do but it is a big deal for a big company to change auditors, change law firms. The IT departments, I—you know, we’ve got dozens and dozens of IT departments at Berkshire. I don’t know how they run. I mean, but we went around and asked them and you find out that there’s—they very much get working hand in glove with suppliers. And that doesn’t—that doesn’t mean things won’t change but it does mean that there’s a lot of continuity to it. And then I think as you go around the world, IBM, in the most recent quarter, reported double-digit gains in 40 countries. Now, I would imagine if you’re in some country around the world and you’re developing your IT department, you’re probably going to feel more comfortable with IBM than with many companies.

Essentially, Buffett is saying that IBM is so entrenched with IT departments around the world that they’re not about to get replaced. IBM is so big and respected that if you need to hire a tech services company, IBM is the safe bet.

IBM has been struggling a bit for a few years now. Revenue has remained pretty flat, and the company has been doing stuff like getting out of PCs and into cloud based stuff. It’s sold off or shuttered lower margin businesses. The result has been steadily increasing margins, but revenue that’s slowly declining.

And yet, earnings are growing at a nice clip. Here’s earnings for the last 5 years.

  • 2010 – $11.52
  • 2011 – $13.06
  • 2012 – $14.37
  • 2013 – $14.94
  • 2014 (est) – $15.96

Based on a $191 stock price, IBM trades at 12 times earnings.

If revenue is isn’t growing, how is IBM increasing earnings per share? By buying back a whack of stock.

Here’s how many shares are outstanding at the end of each year.

  • 2010 – 1.287 billion
  • 2011 – 1.213 billion
  • 2012 – 1.155 billion
  • 2013 – 1.103 billion
  • 2014 (end of June) – 1.005 billion

Now that’s a share buyback. 25% of the float is gone in 5 years. Sure, it’s been borrowing to buy back those shares, but it makes loads of sense.

IBM has also been increasing the dividend.

  • 2010 – $2.50
  • 2011 – $2.90
  • 2012 – $3.30
  • 2013 – $3.70
  • 2014 (on pace for) – $4.40

But because it’s been decreasing the share count so aggressively, the actual dollar amount it pays out to shareholders has remained pretty steady. Additionally, you can see just how tiny the payout ratio is. The company is estimated to earn $16 per share in 2014, but is only going to pay out a little more than a quarter of it in dividends. There’s huge potential for IBM to increase its dividend.

So here’s the question I have. Why Coca-Cola, and why not IBM? The latter trades at a P/E ratio of nearly half of the former, is doing a much better job of buying back shares, and is actually being prudent about it. It’s far smarter to buy back shares at 12x earnings than it is at 22x. One gets you an 8% return, the other doesn’t even get you 5%.

Both companies are borrowing money at around 3% to buy back shares. IBM’s borrowings make a whole lot of sense. Coke’s just exist to fool investors into thinking management’s options aren’t so bad. Bash share buybacks all you want (and I have before), but in this situation the answer is obvious. You can make the case for IBM’s shares being undervalued. You can’t really make the same case for Coca-Cola.

If IBM buys back another 10% of its shares over the next two years and keeps its earnings steady, you’re looking at a company that’ll earn approximately $18 per share on a 900 million float. Without increasing earnings or revenue a dollar, IBM will go from earning $16 per share to nearly $20 per share. That puts the company at a P/E ratio of less than 10 times 2016 earnings with it just maintaining what it already has.

That’s the kind of share buyback investors want to get behind. Forget Coca-Cola. Buy IBM instead. It could be up 50% in a couple years if it figures out how to start growing again. It’s a cash generating machine. I can see why Buffett likes it so much.

Tell everyone, yo!