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Warren Buffett, chairman of industrial conglomerate Berkshire Hathaway (NYSE: BRK-B), is one of the most legendary investors of all time, and one of the richest individuals on the planet. And yet, even Buffett is not immune from criticism over his stock picks.
Buffett took a lot of heat last year when Berkshire increased its holdings of technology giant International Business Machines (NYSE: IBM). IBM has been stuck in a difficult turnaround, as it attempts to move away from old areas such as technology hardware toward newer growth segments.
At long last, it appears this strategy is finally working. IBM stock is up 16% year-to-date, which has outperformed the S&P 500 by more than 10 percentage points since the start of 2016.
IBM has dogged Buffett over the past year, but it looks like it’s Buffett who may have the last laugh.
Big Blue Gets its Groove Back
As of March 31, Berkshire Hathaway owned slightly more than 81 million shares of IBM stock, making the stock Berkshire’s fourth-biggest holding. Based on current prices, Berkshire’s investment in IBM is worth more than $12 billion. Berkshire owns 8% of IBM shares.
Such a large investment has opened up Buffett for criticism, because IBM has suffered 17 consecutive quarters of declining revenue.
But IBM is gradually making progress with each passing quarter. Last quarter, IBM earned $2.95 per share. This was a year-over-year decline, but analysts were expecting $2.89 per share. IBM’s revenue beat expectations as well.
The revenue declines are slowing, which could imply that IBM is on the doorstep of a return to growth. Revenue declined last quarter by just 3%. Its hardware based businesses continued to deteriorate last quarter, but IBM is replacing this lost revenue with higher-growth businesses.
IBM’s strategy is to focus investment on these high-growth businesses, which are collectively termed the strategic imperatives. These businesses include the cloud, mobile, security, and big data. Collectively, these businesses grew revenue by 12% last quarter, and they now comprise 38% of sales.
Indeed, the growth potential of these new focus areas is impressive. Last quarter, IBM’s cloud revenue soared 30%. Revenue from mobile and security increased 43% and 18%, respectively. As these businesses continue to grow at high rates, it will not be long before the strategic imperatives make up the majority of IBM’s total revenue.
IBM Turnaround Takes Shape
Often to as the Oracle of Omaha, Buffett clearly knows a good value when he sees one. IBM has experienced a hiccup in its growth, but the company is still profitable and generates high returns on capital.
A key part of IBM’s strategy is that it is replacing slow-growth businesses with higher-margin, more profitable businesses. This is critical to understand because it means IBM can continue to grow free cash flow, even if total revenue remains flat.
IBM has generated $13.1 billion of free cash flow over the past 12 months. With such strong free cash flow, IBM rewards patient shareholders with significant cash returns. In the past year, IBM returned $9.2 billion of cash to shareholders through dividends and buybacks.
IBM Stock: Don’t Forget the Dividend
IBM is a strong dividend stock, which at least helps pay investors well to wait for the turnaround. IBM stock offers a 3.5% dividend yield, and the company has increased its payout for the past 21 consecutive years, including a 7.7% increase earlier this year.
And, future dividend increases are likely—IBM now has more than $10 billion of cash on the balance sheet. This is plenty of cash to allow the company to continue investing in its key growth initiatives, and also to provide shareholders with an above-average dividend.
IBM could have further room to run. At 11 times earnings, the stock still appears undervalued, considering the S&P 500 Index trades for 20 times earnings right now. IBM’s long-term strategy is taking shape, and as a long-term investor, Buffett may have the last laugh after all.
Disclosure: Bob Ciura is personally long IBM.