Warren Buffett's second- and third-quarter purchases of International Business Machines Corp. (NYSE:IBM) last year sent a shock wave through the investment community; for the first time ever, the Oracle (NASDAQ:ORCL) of Omaha had invested in a technology company. Clearly he believes the company has a defensible moat and will continue generating strong earnings for decades to come.
Now, many months after Buffett first revealed his position in the company, the stock still trades in the same price range in which he bought it. This means that investors can still buy IBM at a price that Buffett deems fair. But should the individual investor really buy IBM at this price?
Besides price, the most important determination of success for a company is the strength of the underlying business. IBM is a great business as evidenced by its high return on capital. Its high return on capital allows it to earn higher incremental revenue on incremental assets added to the business. For illustration, IBM's tangible assets declined at an annual rate of 3.23% over the last decade while sales increased at an annual rate of 3.11%. IBM is earning more money on fewer assets. That's a great business, and it's the kind Warren likes to buy.
IBM faces competition from companies of all sizes in many different categories. Oracle is one of its fiercest competitors. Like IBM, Oracle offers a wide range of services to its customers and acts as a one-stop shop for many large- and mid-sized companies's IT needs. In addition, its big data applications are experiencing rapid adoption and out-competing smaller firms like Splunk Inc (NASDAQ:SPLK). Oracle also has a dominant position in database technology, including the rights to the popular MySQL database, which differentiates it from IBM.
IBM has ample opportunity to expand in emerging markets. As the BRICs develop more sophisticated financial markets, they will inevitably need IBM's mainframe computers to operate soundly. Neither Oracle nor Cisco offers as wide an array of services as IBM, which makes it the logical choice for these emerging economies.
Is International Business Machines Corp. (NYSE:IBM) a good investment?
Over the last three years, IBM has averaged $15.6 billion in free cash flow, or $13.68 per share. If you divide $13.68 by the share price ($195.40), you get an initial yield of 7%. In other words, IBM's current free cash flow level offers a 7% annualized return for investors who buy shares today. Investors who want a higher return will have to hope that IBM will grow free cash flow faster than inflation. In other words, they must pay for growth.