IBM as myth and warning
(Note charts mentioned cannot be reproduced here)
IBM’s spin-off of its data centre services business became official yesterday, when Kyndryl began trading. The new company fell more than 7 per cent in its debut, a fitting end to one of the stock market’s favourite morality tales. It’s a story about how greed, taken too far, is self-defeating.
It starts in the 1990s, when IBM was close to bankruptcy, its core mainframe business having been ambushed by the personal computer. But a shift into technology services and consulting brings the company roaring back. But IBM’s commitment to technological excellence was soon replaced by a love affair with earnings growth. In 2010 the company said it would double earnings per share, to hit $20, in five years.
Earnings rose at first, drawing Warren Buffett into a huge investment in 2011. But the company was milking its cash cows, cutting expenses, underinvesting and missing the future. It was tragically late to the big shift to cloud computing in the last decade. The stock peaked in 2013, and IBM earned $6 a share last year. Here’s the chart:
I like this story; it appeals to my prejudices. But I wonder if it is true and — more importantly — whether the humbling of IBM could have been foreseen in advance. So I had a look at the historical numbers. Here are three decades of annual revenue, gross profit and earnings per share. The red line marks the moment the stock peaked:
The interesting thing is that revenue started moving more or less sideways in 2008, years before the stock noticed that anything had gone wrong. It’s pretty likely that investors were distracted by the roaring increases in earnings per share. But the continued rise in gross profit was important too. I know this because I worked for a value investor at the time, we owned the stock, and all we cared about was the fact that gross profit dollars went up, quarter after quarter.
Gross profit is, in fact, very important. As I have written before, gross profit is what happens when you can sell your product for more than it costs you to make. It means you are adding value and have pricing power. All other measures of profit are derivative of it.
But those increasing gross profits (and per-share earnings) need to be put in the context of this chart, of spending on research and development and fixed investment:
IBM has always spent a lot of money on R&D, but that spending flatlined starting in 2004, even as earnings per share growth was accelerating. And as for capital expenditure — well, look at the chart.
Now, it may be that as IBM moved into services, it needed less capital investment. But that R&D drift is a warning sign. Compare its research spending and capex to Microsoft’s:
Where was IBM spending money? On shareholders:
The numbers — at least at this high level of abstraction — line up with the myth. Investment fell as EPS and payouts rose, and this proved unsustainable. Rising gross profits fooled people like me, because they were driven not by the creation of new value but (to hear old IBM-ers tell it) by squeezing customers who were bound to the company by high switching costs.
This morality tale matters because IBM is one of the greatest companies that has ever existed. According to calculations made by Hendrik Bessembinder, as of 2018, it had created more shareholder wealth in its history than all but four other companies.
We live in an era dominated by a handful of companies that appear to have permanent competitive advantages. It is worth remembering how great companies can fall low.