Back in 2011, Warren Buffett's Berkshire Hathaway (NYSE: BRK.A) (NYSE: BRK.B) bought a 5.4% stake in IBM (IBM 0.06%) at an average price of $170 per share. That $10.7 billion investment surprised many investors since Buffett had famously avoided buying tech stocks throughout most of his career. But by the time IBM's price sunk to the $140s in mid-2018, Berkshire had liquidated its entire position in the aging tech giant.
Today, IBM's stock trades at about $130, so if you had followed Buffett's lead and invested $1,000 into IBM at $170 a share in 2011, your investment would only be worth $765 today. The same investment in an S&P 500 index fund would have more than doubled. Let's see why Buffett bought IBM, why it underperformed the market, and how Big Blue plans to stage a comeback.
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Why Buffett was initially drawn to IBM
In 2010, IBM's then-CEO Sam Palmisano claimed the tech giant could double its annual earnings per share (EPS) from $10.01 in 2009 to $20 by 2015. He aimed to accomplish that "Roadmap 2015" goal by cutting costs and spending billions of dollars on share buybacks.
That plan impressed Buffett because IBM seemed undervalued relative to those growth rates. At $170, IBM was only trading at 13 times its 2011 earnings. Upon revealing his investment during an interview on CNBC in November 2011, Buffett said IBM's business was sticky because it's a "big deal" for a big company to "change IT support", and there's a "fair amount of presumption" among enterprise customers that if "you're with IBM, you stay with them."
How IBM fell behind the tech curve
IBM's business was sticky, but it was also growing at an anemic rate. To squeeze more EPS growth out of its sluggish sales, IBM aggressively cut costs, divested its lower-margin business units, and plowed most of its free cash flow into big stock buybacks.
But as IBM burned the furniture to stay warm, it underestimated the growth potential of Amazon (AMZN -2.56%), Microsoft (MSFT -1.27%), and Alphabet's (GOOG -1.10%) (GOOGL -1.23%) Google in the cloud infrastructure platform market. That seismic shift in the tech world prompted many large enterprise customers to migrate their data from IBM's on-site servers to Amazon Web Services (AWS), Microsoft's Azure, and Google Cloud Platform (GCP). Upon locking in those clients, Amazon, Microsoft, and Google rolled out more cloud-based enterprise software to increase the stickiness of their ecosystems. IBM's myopic focus on near-term profits and its failure to invest in the cloud caused it to fall behind that crucial tech curve.
Why IBM failed to fix its business
Ginni Rometty, who succeeded Sam Palmisano in 2012, realized that IBM could be rendered obsolete by those growing cloud infrastructure platforms. To stay in the race, IBM hastily acquired the cloud platform provider SoftLayer in 2013.
Unfortunately, SoftLayer was designed for small to medium-sized businesses, and its offerings seemed primitive compared to those of AWS, Azure, and GCP. IBM tried to upgrade SoftLayer by bringing on new teams and developing new features, but those efforts were stunted by internal conflicts. At the same time, IBM continued to divest itself of its weaker businesses and buy back more shares.
But those buybacks couldn't offset the impact of its declining revenues. In late 2014, Rometty admitted that IBM's EPS couldn't possibly reach $20 by 2015. Between 2014 and 2020, IBM's annual revenues declined from $92.8 billion to $73.6 billion as the contraction of its legacy businesses offset the growth of its cloud-oriented businesses.
What are IBM's plans for the future?
Current CEO Arvind Krishna, who took the helm in 2020, is trying to revive the tech giant with three core strategies. First, IBM spun out its slow-growth managed infrastructure services business as Kyndryl (KD 0.10%) in November 2021. Second, it is expanding Red Hat, the open-source software giant IBM acquired in 2019, with more AI and hybrid cloud services that can be wedged between private and public cloud platforms. That niche approach could enable it to capitalize on the growth of the AI and cloud markets without going toe-to-toe against Amazon, Microsoft, and Alphabet. Lastly, it plans to further streamline its business by cutting thousands of jobs and replacing a large portion of those positions with its AI services.
IBM's revenue and adjusted EPS finally rose 6% and 15%, respectively, in 2022. For 2023, it expects its revenue to rise by 3% to 5% on a constant-currency basis as its annual free cash flow increases by 13% to $10.5 billion. Analysts expect its reported revenue and adjusted EPS to both grow by about 3% for the year. For 2024, they expect its revenue and adjusted EPS to rise 4% and 6%, respectively, as the macro environment improves.
We should take those rosy estimates with a grain of salt, but they suggest that IBM could have a brighter future as a streamlined hybrid cloud and AI company. Trading at 13 times expected forward earnings, IBM's stock is just as cheap as it was when Buffett bought his big stake -- but the company has learned from its mistakes over the past decade. And as it gradually turns around its business, it will also reward its patient investors with a dividend that, at today's share price, pays a high yield of 5.2%.
