IBM continues to confound and amaze

Author: Barry Randall, Crabtree Asset Management

Covestor model: Crabtree Technology

January 2012 was a strong month not only for the Crabtree Technology model, but also for the capital markets as a whole. A steady stream of solid economic news, such as three-year lows in the weekly U. S. unemployment claims, bolstered confidence in general and investor confidence in particular.

In the world of technology, however, there were hits and misses, particularly when it came to reporting December quarter earnings. There were very solid reports from Apple, IBM and Netflix. Conversely, Google and Amazon disappointed, causing each company’s stock to decline sharply the day after each reported numbers.

Among Crabtree holdings, IBM (IBM), Electronics for Imaging (EFII) and OSI Systems (OSIS) were the standouts, in each case exceeding expectations and offering forward outlooks ahead of expectations – either their own prior outlook, or Wall Street estimates.

Disappointments came from Symantec (SYMC) and Electro Scientific Industries (ESIO), though neither of those two companies’ quarters would be considered to be “blow-ups” in Wall Street parlance.

Nonetheless, February will bring with it a rebalancing of the Crabtree Fund, and those companies failing to exhibit the key Crabtree characteristics (e.g. execution on their business model) will be swapped out for those still possessing them. Of course, earnings season for the December quarter won’t be over until mid-February, so we’ll have more to say in next month’s report, plus an update on the fund’s composition, which will have changed by then.

Because we don’t really “react”  to the general economic and financial news flow by selling current holdings or buying new ones, we typically don’t pay too much attention to the daily headlines. However, we do have strong feelings about certain companies. Here are a few words about this month’s featured Crabtree holding, IBM.

IBM continues to confound and amaze people. The most recent surprise was when notoriously tech-averse billionaire Warren Buffett took a large position (is there any other kind of Buffett position?). But we think that Mr. Buffett simply came to understand what we have known for many years: IBM doesn’t manufacture business machines. They manufacture earnings. They do so as follows (source – IBM reports and Yahoo Finance):

  1. IBM runs a very profitable technology services business ($40.9 billion in 2011 revenue; 35% gross margins), and charges their service clients for the computer hardware and software they install, generating…
  2. …prodigious cash flow (18.5% operating cash flow margins) with which they…
  3. …buy back stock (paid $15 billion in 2011) and …
  4. …acquire more high-profit margin software companies (spent $1.8B in 2011) whose products they sell…
  5. …through their very profitable technology services business, repeating this cycle over and over.

To put some more numbers to this amazing machine, consider that at the end of 2011, IBM had 1.189 billion shares outstanding, down from 1.605 billion shares at the end of 2005. That’s an astounding 26% decline in the share base, or a 35% boost to earnings per share, absent any other effect.

IBM hasn’t really amazed us at Crabtree. We cottoned to their secret strategy years ago. It is an example of why we generally pay no attention whatsoever to a “tech”  company’s technology and focus almost exclusively on a company’s business model and market opportunity. Sure, IBM created Watson, their Jeopardy-winning supercomputer, but it is the aforementioned acquisition/cash flow/buy-back cycle that keeps us as investors. IBM has been a holding in the Crabtree Fund since we started it nearly three years ago. Welcome aboard Warren!

Well, that’s all for this month. February will bring many more earnings reports. Plus, Facebook just filed for an IPO yesterday, so we’ll be digging into their SEC filings. We’ll have completed our quarterly re-balancing of the Crabtree Fund by the end of February, so we’ll let you know about what’s new in the portfolio.  See you then!

  • http://pulse.yahoo.com/_H63WN56MHMP2D6OSCX7WLFKUE4 Dan

    the number crunchers of Unemployment CLAIMS , of a “3 YEAR LOW, is MISLEADING!! 
    The reason the decreased claims over a 3 year low, is because people have exhausted, their time-period for RECEIVING  benefits!!   and also, people have NOT been losing their jobs, AS FAST as BEFORE!!!!   Statisics, can be MISLEADING!!!!!!!!!

  • http://pulse.yahoo.com/_H63WN56MHMP2D6OSCX7WLFKUE4 Dan

    i agree.

  • http://pulse.yahoo.com/_OEIWCXNW7JWTU6XUKWPBSNKXAI whiffer

    There is part of the quotient that hasn’t really been highlighted here.  IBM’s customers pay through nose for their services.  Maybe grudgingly so, but they still pay.  Just based on shear size, IBM can create corporate engagement which pay them premium fees.  this has shown little sign of stopping.

  • Tshutze

    IBM charges a lot because they give a lot to the customer.  They are superior in every way.  They hire the best people, give the best service, are stable and dependable.  The customers know they are in the “Best Hands” when dealing with IBM.

  • Richopp

    IBM’s business model was set years ago when the company was facing the changing world of technology and learned that, having missed the opportunity to own the PC space and not buying Microsoft when it was offered in the early 1980′s, they needed to retool the company and enter the profitable services business, which they had already been in with the government for many years.  Using this model, purchasing a huge consulting company, and leveraging their scorched-earth approach turned the company from technology innovation and sales to mostly a consulting and services company.  Hardware at the very high end is still a winner, and their R&D investments pay off with thousands of patents each year in a huge portfolio that generates a steady income stream.  As hardware became a commodity and small software firms became their bullpen, IBM has proven that being smart is still a winning strategy regardless of what the anti-intellectual crowd is preaching on the campaign trail these days.
     
    Unfortunately, many former employees have been treated very poorly by a company that has changed from one that was pretty flat top-to-bottom to a typical US company run by a greedy board and greedy executives who now take all the cash for themselves and treat their employees with great disdain.  Everyone knows that they look at the cash balance in the pension fund hourly and try to figure out how to get that cash into their personal pockets, not the corporate treasury, so that the top 5 execs can join Gates et. al on the richest list.  This is the new model that Gerstner and York brought in when they “saved” the company and, unfortunately for the employees, they are now cattle feed.  People forget that employees react to disdain negatively.  I am certain that the spirit of IBM is long gone.  What you have now is a money machine, which of course makes wall street happy, along with the top IBM execs who get obscene sums of cash for merely doing their jobs.  IBM is rich enough to go back and treat their employees like they used to, buy why?  All 60-year-old people need another 100 million or so a year to supplement their social security, right?  I mean, how can a person live on a mere million or so a year pension?  A very sad American story that will eventually come back and bite the greedy as it always does.

    • four niner twenty three

      >> turned the company from technology innovation and sales to mostly
      >> a consulting and services company.

      >> IBM has proven that being smart is still a winning strategy regardless
      of what
      >> the anti-intellectual crowd is preaching on the campaign trail
      these days.

      >> Unfortunately, many former employees have been treated very poorly

      >> and, unfortunately for the employees, they are now cattle feed.  People
      forget that
      >> employees react to disdain negatively. 

      >> A very sad American story that will eventually come back and bite
      >> the greedy as it always does.

      it is sad, but many people *like* the fact that merit, creativity, honesty, respect, integrity,
      ingenuity, and compassion have no sway or value; all that matters is
         who can buy their way into the club (and, more importantly, who cannot)

      they will get what’s coming to them.

      they will get exactly what they deserve.

      >> I am certain that
      the spirit of IBM is long gone. 

      It may be long gone, but that is the one assurance we have that it is
      still alive. maybe it escaped when it still could. maybe it knew that
      was the only way it would survive.

      maybe it had an ounce of self-respect, and knew that staying was suicide.

      maybe it is stronger than ever.

      maybe it will even return some day.