Buffett Breaks His Cardinal Rule And Invests In IBM (Technology) - Part Two
This is the analysis section of the two-part post on Buffett's investment in IBM. The first part was simply setting a baseline of prior remarks, outcomes, etc. As you read this post, I hope you will gain an appreciation for a greater reality than what is presented by the financial clowns on Wall Street and the massively incompetent marionette politicians they control. After reading this post, I hope you have an appreciation for how unstable the entire economic system is. Even areas of the economy that you may have never questioned like IBM. This is not a banking crisis.
As you read this, you may ask the question of how Warren Buffett and I, as an example, can look at the same possible investment or data and come up with two wildly conflicting conclusions? This can be surmised in one word. Quality. The world can only be explained by quality. But quality requires an appreciation for the esoteric factors of life. Economics, finance, politics and the like in today's world are most often completely void of the concept of quality. They are void of quality because these institutions are controlled by bureaucrats. Small-minded drones who wax poetic about efficiency and numbers when talking about human beings and the quality of our existence. Just like in the Soviet Union and Nazi Germany.
bu-reau-crat [byoor-uh-krat] noun - an official who works by fixed routine without exercising intelligent judgment.
We are all suffering the consequences of this fact. We suffer because bureaucrats subvert human expression, truth, reason, creativity and quality through political and corporate control. Let's now delve into the exploration of quality.
In many ways IBM, HP, Oracle, Dell and a few others in this field have become economic parallels to the Big Three auto makers and the Big Wall Street firms. They are the GM, Ford and Chrysler or Bank of America, JP Morgan, Lehman, Bear, Morgan Stanley and Goldman Sachs of the IT industry. They are all oligopolies or economic fiefdoms that rely on a form of political entitlement and associated control to survive and thrive. That entitlement is the pro-business corporate socialism or fascism supported by both political parties in our nation as well as countless other nations around the world; the foundation of neoliberal globalization. They use this political entitlement to affect economic policies that subvert working markets/competition, competition for American labor and most importantly to subvert job creation. --> Companies, once they gain control of markets, destroy job creation. Companies don't create jobs, people do. And people do through working markets. Having a government that is pro-business is a government that is fascist. Romney, Clinton, Reagan, Bush, Obama; it matters not. They are all pro-business.
Obama's calls to American multinationals to hire American workers by invoking some level of patriotism or nationalism are naive and ignorant of fundamental economics, corporatism and the policies he supports. Policies that continue to destroy the American economy yet line the pockets of political parties with corporate-looted cash. For now.
First, let's take a specific look at some of the "high value" lines of business that IBM and other major firms within the IT industry and how they are being set up for a major crises in coming years. Crises that will almost certainly be every bit as serious as those the financial industry has experienced. Probably worse than anything we have seen to date. Once again, this is not a financial crisis as Obama, Geithner and 99.9% of economists would have you believe.
IBM and other major business-focused information technology businesses have become more software-centric in their business model over the last fifteen or so years. This is driven by an attempt to increase margins and provide more predictable earnings over the business cycle’s earnings volatility. Yet, this relatively new phenomenon of large, predictable software revenue streams is substantially comprised of recurring payments achieved both through software product upgrades and maintenance fees. Both of which are increased quite substantially on a regular, mostly annual, basis to increase corporate profitability. This is similar to the massive and unyielding increases of health care costs that rises annually in the double digits as corporations pilfer society's sick and vulnerable to pad the bottom line with predictable earnings.
This software pricing model is completely unproven on the scale it has now being instituted. Rented software was popular many decades ago when IT was a new industry. At that time customers saw massive productivity improvements with the advent of the large scale business computers and the first implementations of automated processes. But, today's environment is vastly different. There are generally little to no productivity improvements garnered in today's world regardless of any economics or corporate propaganda to the contrary. What is now measured as productive gains are actually coming from massive corporations seeking to tie together disparate applications acquired through the mergers and acquisitions bubble.. This environment is driven by the corporate world's desire to become ever-larger and thus control markets and competition through acquisition. IBM and other leading business software firms are focused very heavily on this concept of "big data". Yet, this dynamic is not driving society's productivity. Instead this dynamic of becoming every larger has turned our economy into mega Soviet-style state corporations that are killing our economy, invention and job creation. Remember, one of our themes on here is that this cycle could be coined the end of big be that government, corporations or other institutions of the ego. Large firms seeking to achieve some level of commonality and standardization of big data, that have become the core customers of the likes of IBM, are, in fact, all too big to fail and as we have noted, they most likely will fail to some degree. In other words, they will come out of this environment a fraction of their existing size or they will fail completely. Through the supply chain, we can expect IBM and others focusing on big data to experience the bullwhip effect wrote about years ago.
This latest software business model of predictable and large annual pricing increases is based on one unsustainable premise. Control. And, Wall Street was all too willing to oblige as all of the large business software firms have been on a massive consolidation binge to take out their competitors and destroy working markets. This too is a leading dynamic behind big data. That, and the greater rise of state control. Not too many years ago there were hundreds of viable solution providers in the mainstream business software space. Now there are a handful. In other words, both the economy’s productivity and its money supply statistics were being inflated through the destruction of our economy thanks to Wall Street, politicians, the Federal Reserve and corporate bureaucrats; something we have hammered on here but seems to be lost upon economists and monetary dunces like Alan Greenspan. (Alan Greenspan truly is an idiot and exhibits none of the characteristics of the Maestro moniker given to him by other equally incompetent Wall Street bureaucrats. Another bit of Amerika's Orwellian corporate belief system.)
In some ways this software business model is very comparable to the debt serfdom we see banksters attempting to inflict on society. A dynamic driven by corporation's search for greater profits and, thus, control. But, the serfdom in the case of business software firms are unsustainable, predatory software annuity streams (annual debt taxes) enforced by the likes of Oracle, SAP, IBM, HP, Cisco, Dell and EMC. Make no mistake, these companies are predatory in their methods used to enforce these software revenue streams and pricing models just as Wall Street uses predation to enforce its debt serfdom, just as the industrial food monopoly uses predation to enforce its toxic food serfdom and just as the health care monopoly uses predation to enforce its unsustainable pricing predation and serfdom. When the corporate profit bubble pops, just as the housing bubble fueled massive Wall Street profits, IT business models for major purveyors are going to be devastated. You mark my word. When I wrote seven years ago of IBM’s stock taking a dive to as low as the mid 20s, I wasn’t just whistling Dixie. My experiences working in management consulting and information-based solutions gives me a very unique perspective on corporate America’s strategies and vulnerabilities. This is going to happen.
Small perturbations are already being felt in this space. But, no one is listening. Or no one that understands what is really going on in the global economy. Similar to the volatility surrounding the revolt against debt serfdom, corporate software customers are already starting to change their behavior. I have seen some plausible analyses that place global business clients some $300 billion dollars in arrears in their software upgrade and maintenance cycles. Client companies simply aren’t going to keep forking over predatory software fees just because it benefits the bottom line of IBM, Oracle, HP or SAP. And, software upgrades are incredibly expensive beyond the incredibly expensive initial price. If the upgrade version fee from a software provider is $1 million, it could take as much as $5 to 10 million or more in additional costs in the form of version dependencies of other software, modifications to applications, new systems software, systems, labor, etc to make these conversions. In other words, change management. So, an estimate of $300 billion of arrearage in upgrade costs could easily be the tip of a multi-trillion dollar future obligation for software clients. We can more than likely expect this model is going to bust just as the debt-based serfdom model is busting. We can expect the predictability of software revenue streams and associated profitability is more than likely going to turn out to be a myth as the global economy continues its death spiral. So too will the predatory business software space start its death spiral. No one in this industry is prepared for this coming dynamic. No one even sees it coming.
IT and Business Services
We can apply the same dynamics and rationale of software with the relatively recent (last fifteen years or so) surge in services that companies such as IBM, HP, Dell, CSC, Accenture and half a dozen other major firms rely on for predictability of earnings. In other words, this too is a business that was embraced to smooth cyclical earnings and it too is a form of serfdom created through customer-provided annuity. Additionally, one of the major services embraced within the business process space, outsourcing, is predicated on a social belief system rather than a universal truth or fact. Savings from outsourcing or offshoring are seldom realized. If I am frank, they are almost never realized. Nor are the business process improvements that are promised. And, the soft costs of outsourcing, which are hard to quantify but impact the bottom line with hard dollars are oftentimes more substantial than hard costs. These factors are completely discounted. ie, The negative intangible effects are substantial. There are substantially more esoteric and intangible losses associated with client experiences, loss in quality, less qualified talent, etc. Or, with internal corporate customer experiences due to time zone, language and competency dynamics.
But, far and away the biggest driver of this trend of offshoring and outsourcing is that companies are simply too large to manage. No single team can manage effectively manage a firm over a few thousand people. A firm with tens or hundreds of thousands of employees does not win in the market place because of merit. They win because of girth that forces out competition. They control and manipulate the marketplace in some fashion, mostly by legalized political bribery to rig the game. So, much of this services dynamic involves shedding parts of the business that are not considered core (outsourcing), and arbitrarily/ignorantly might I add, to management’s success. That includes human resources, IT, manufacturing and logistics to name a few. In other words, employees, technology investment, manufacturing processes, capital investment and logistics are treated as a commodity rather than a competitive advantage. Services outsourcing is based on a presumption that what were once high value differentiators and key investments are now commodity. This is a fool’s game that is going to have tremendous unintended consequences in future failure.
Very importantly, maybe more so than anything else, there is no moat around services. This business model is incredibly vulnerable to a shift in trend or ever-changing social values. It's no different than the restaurant business. In fact, the restaurant business is a perfect analogy to the corporate outsourcing services market. As economic dynamics change, I, as a consumer, have a greater ability to control my finances and the quality of my food by dining at home. That hurts the restaurant business in tough economic times. The same exists with IT and business services. If I bring those services in house, I have more control over quality, efficiency, investment and flexibility. As long as monopoly and oligopoly dynamics exist, these factors are irrelevant. But, monopoly cannot sustain itself without the force of the state. So, at some point government must decide if it wants to create jobs or continue to support corporate welfare for firms too big to fail. We know where this all ends up as the system continues to unwind. The profit bubble fueling the lobbyist bubble is going to pop. It's an economic fact that it must. It's only questionable whether it will pop due to proactive economic policy changes or further economic crises created in large part by corporate welfare and political dunces.
The massive outsourcing and offshoring dynamic that exists today is nothing more than a social trend enabled by unsustainable, predatory factors and rigging of the economic game by special interests. Factors that subvert democratic economics. Social values are most often corrupted and tainted by mob behavior, propaganda, immorality, corruption, looting, bribery or worse. The dynamics driving outsourcing and offshoring are no different. That our government actually incents corporations to offshore jobs is a sign of how immoral our politicians truly are. This dynamic is equivalently nothing more than what would be considered a fad in the consumer space. If fad is a term that can be used to describe business dynamics, then offshoring and outsourcing are fads. Half a dozen years ago I wrote on here that this trend was in its final phases. It's end most likely will come quickly and violently. Capitalism is a creation of the state. So, as government corruption and statism creates more crises, and these dynamics are collapsing on every continent, both of these dynamics, a product of state corruption and the collapse of economic democracy, will collapse with them.
IBM has moved a substantial amount of its core research and development business overseas and now gets less than half of its revenue in the United States. A change in the down draft of the dollar that we have been writing about (a coming rise, possibly violently so, in the dollar) or a change in how country to country trade settlement is managed (that we have said was coming half a dozen years ago) is likely to play a role in determining the fate of international profits of countless companies. In fact, it isn't beyond the realm of possibility that entire overseas investments by international firms could be lost entirely as I noted in a post regarding China five years ago. If governments slap currency controls or nationalize economic assets, as has happened at different times in history, entire international investments could be completely lost. This doesn’t even take into account supply chain shocks and social upheaval we have been anticipating for years that is now becoming a reality around the globe. These dynamics will most assuredly impact global corporations substantially and negatively. Control is an illusion.
These business models worked as long as neoliberal economics worked. Now that the global economic model is imploding, we can expect to see the same dynamics that are affecting the globalization of finance to impact the globalization of nonfinancial corporations. Remember, we have uniquely said for years that globalization is dead and global finance is dead. It’s coming. IBM, HP, Oracle, SAP, Dell, EMC and others are most assuredly not prepared and neither are any other global hegemonies, oligarchies, monopolies and governments.
Neoliberal Corporate Business Strategy Of Today (Courtesy Of The Idiocracy Better Known As MBA Schools)
Let me say that IT and business consulting firms are poster children for neoliberal or trickle down economics as espoused by President Obama and would-be President Romney. Both men are firm advocates of neoliberal fascism through their own separate but similar messages. Obama's message is that in order to compete in the global economy, we need to send more kids to college to serve as cubicle drones for our corporate masters. That is, even though we already graduate 70% more kids from college than, as an example France. In order to achieve this dynamic we need to either dumb-down education (which has been under way for decades) or create an even larger education bubble or a little of both. This policy leaves behind the vast majority of the population who either doesn't wish to participate in the corporate-created dream of economic enslavement or who have found themselves on the outside looking in with non-living wage corporate-drone jobs or an inability to compete for a college education for various reasons.
All industries participate in this mythology. One method that corporations oblige this policy by jettisoning "commodity" or perceived low-value businesses and moving upstream to "higher-value" opportunities. These opportunities are mythical. They aren't higher value. They are, in fact, higher-risk delusions. Moving up the food chain to higher value is a standard outcome to neoliberal trickle-down economics. Making things or doing real work that benefits society has been replaced with pushing paper and doing each other's laundry aka corporate services work; both of which are consumers of capital, create zero net-new wealth and, are in fact, lower-valued forms of work. New "new economy" is a myth perpetrated by economic dunces and political stooges who have turned our economy into a hollowed-out humpty dumpty that creates almost nothing other than bombs & money printing and accomplishes even less. The godfather don of this dynamic is Ronald Reagan and his voodoo economics; a term coined by his political competition. But, now both political parties embrace this form of corporatism because it lines their pockets of political control.
IBM is the Goldman Sachs of the IT industry. In other words, bureaucrats at all corporations in this industry have embraced a form of follow-the-leader in adopting a similar business model of the perceived industry leader. That transformation is essentially complete. Now the fun begins. Moving to "higher value" lines of business that has also driven a concentration of profitability into its top global clients. IBM and other IT and business services leaders are squarely reliant on the state and massive corporations for the vast majority of their revenue and profits; a manifestation of Pareto's Principle. 60% of IBM's profits come from the massive, systemically-unstable corporations in the finance industry. IBM garners the vast majority of its profits from the top 100 global firms and governments. And, within that, the largest profits come from financial bubble companies. As we noted in a post years ago, IBM’s profits are disproportionately tied to finance and insurance. And, much of the IT spending in these industries has been surrounding trading, speculating, gambling and other highly risky revenue streams that will eventually be exposed as useless consumption of capital. ie, These activities will disappear.
To show you how small business has collapsed in this country, IBM jettisoned its small business focus to resellers over the last few decades. It sells nothing directly to small and medium business while that was once a focus market. It’s business model is focused on efficiency rather than service. So, it only directly focuses on the top 20% of its customers. In other words, the world’s largest corporations and large government bureaucracies; 80% of profits come from 20% of clients. Those that are systemically-unstable and showing signs of failing everywhere in the world today.
Just a reminder... one of our long term theses on here is this is the cycle of the end of big and that we are in the largest financial bubble the world has ever seen.
As it pertains to the financialization of our economy, IBM and other corporations have often hollowed out capital development and production in favor of more predatory practices including those we noted above. Additionally, IBM, as is the case with just about every major firm in this nation, has a very large direct involvement in finance. IBM has a captive bank that it uses to facilitate trade and profitability. We've already seen signs of this dynamic unwinding in GE, Harley Davidson and the Big Three auto companies just to name a few that also have their own banks. Banks that started collapsing before the massive bailout provided by little old grandma's savings and Social Security checks. By the way, this is also the same dynamic used by China to grow its economy. ie, China acts as a bank by extending credit to nations around the world through the purchase of their debt. This was also a major dynamic behind the Great Depression. Watch and learn as the end unfolds.
This is the most horrific and telling dynamic associated with IBM and assets in general. Eighty years ago there were a whole lot less public companies trading in this country. Some of that was driven by an economy that was more agrarian in nature. But, don’t be fooled. Much of it was also due to the fact that the Wall Street extortion machine hadn’t yet ramped into high gear through generations of conditioning itself and the public to a false belief system. Wall Street now has made an art of screwing society out of massive amounts of money without anyone realizing it. This is much more prevalent than the financial fraud that existed during the Great Depression. In other words, as a society, we are suffering from mass delusion. That allows investment bankers and private equity to bring almost any company public that has a heart beat. Eighty years ago most companies came public because they had viable business models and wished to tap public financial markets for capital to expand domestic production and domestic employment. That seldom happens today. Seldom. Almost never. Most of the time companies go public so Wall Street and corporate leaders can loot our pensions. They essentially accomplish this by bribing senior executives at the companies coming public by cashing them out. That dynamic of driving so many businesses public has been a major contributor to creating the corporate state. Our businesses are no longer run by those who have a personal vested interest and creativity, its founders, but by bureaucrats. Harvard MBAs that learn theoretical nonsense about Soviet-style efficiency used to run our public companies into the dirt. (efficiency as a form of control subverts quality) Then, as part of that efficiency, bigger is better. The next thing you know, we have three car companies, three computer companies, three major Wall Street firms, three internet companies and on and on and on. The end result are massive Soviet-style state-backed corporations that serve no purpose to society other than to keep the rats running in the maze. Or to keep people employed making and doing useless busy work. The American economic dream is no longer to create value but to now go public and become instantly a multi-million or billionaire at the stock offering and become a philanthropist courtesy of the money that has been looted from our pensions and savings. We don’t need to rely upon ego-driven people who publicly wish to give away the fortune they stole from society. That's Reagan's view of economic neofeudalism.
My point of this last paragraph is there weren’t untold thousands upon thousands of horrible companies publicly-traded as there are today. So, it was the Dow 30 rather than the S&P 500 that was the primary index in 1929. So, in 1929 the average valuation of the top 130 companies was three times book value. IBM is currently trading at thirteen times book value. Mind you, book value’s calculations have been muddled in recent decades so there is some argument in a comparison to the valuations of 1929, it is trading at a much higher multiple of book value than thirteen. And, there are most likely going to be dynamics that actually shrink book value in coming years. That said, its current value is 400%+ more expensive than the average Dow stock was trading at in 1929 at the peak of the Wall Street bubble before the onset of the Great Depression. After which the average stock fell over 90%.
A few years ago Fitch cut IBM’s credit rating for an aggressive buyback that included borrowing tens of billions to buy back company stock. This resulted in higher financial leverage within the company. Not for new product development but to raise the shares for vested executives. A cash flow analysis shows IBM, and for that matter, most major corporation's peak profitability was some quarters ago. We are already on the downward leg of the profitability cycle.
For IBM to trade at the astronomically-inflated values created by Wall Street and political criminals in 1929 before that market crashed, it's stock would need to drop 75% today. Of course, to trade at some semblance of post-1929 and post 2012 bubble collapse reality, it must lose 95+% of its value. Of course, were that to happen, which would simply be a reversion to the mean or a return to reality from the fraudulent economics and political corruption that enabled it, the fundamentals that come with it would ensure IBM and other similar firms will most likely be in a fight for their very survival. The horror of the financial and political corruption that created the modern-day dynamic that defines our financial and economic system is beyond the comprehension of most Americans. Don't worry. For those who refuse to acknowledge reality, who instead prefer to keep voting for their political team to win and deliver more of the same in Obama and Romney and both political parties, a greater truth is in store. You will not escape enlightenment but rather it will be thrust upon you. Most likely violently and without notice.
As we noted before, the vast amount of future invention happens outside of the walls of any specific corporation or institution of control. That we have a culture of massive corporations simply is a reflection of how they rigged the rules to the game similar to how massive state-backed corporations rigged the rules to the game in the Soviet Union. There are almost no technology companies that existed in 1970 that still exist today. 90+% of the technology leaders of 1970 have disappeared. Technology companies today have become monopolies because of deregulation of finance and the subversion of working markets; all enabled by political corruption. In other words, these firms don’t lead through invention but in fact suppress it. These firms don't create jobs, they destroy them. No one defines this fact more than the likes of IBM, HP, Dell, EMC, Accenture, CSC and Oracle as leaders in the IT industry.
Because capitalism is an invention and creature of the state, it's inevitability is tied to the legitimacy of the state's policies. In other words, this too shall pass. Buffett's investment in IBM was clearly not based on investing brilliance but, instead a wild misunderstanding and miscalculation of reality; a hallmark of the status quo.