What were reasons Warren Buffett had for investing into IBM given the rarity of a tech company in his portfolio?

IBM revenue growth

What were reasons Warren Buffett had for investing into IBM given the rarity of a tech company in his portfolio?

Great question. IBM has evolved into less and less of stereotypical tech company. The key to understanding why a Buffett investment is made is to look at the timing and stickiness of the cashflows coming in and going out. Take a look at this part of the 10-K from IBM: "Business Segments and Capabilities". The company's major operations consists of five business segments: Global Technology Services and Global Business Services, which the company collectively calls Global Services, Software, Systems and Technology and Global Financing.

Global Services: is a critical component of the company's strategy of providing IT infrastructure and business insight and solutions to clients. While solutions often include industry-leading IBM software and systems, other suppliers' products are also used if a client solution requires it. Approximately 60 percent of external Global Services segment revenue is annuity based, coming primarily from outsourcing and maintenance arrangements. The Global Services backlog provides a solid revenue base entering each year. Within Global Services, there are two reportable segments: Global Technology Services and Global Business Services."

Did you see the key phrase "annuity based"?

Why did Buffett like newspapers so much? Upfront annual subscriptions that were paid by customers. One upfront payment funded costs and expenses gradually for the rest of the year for the services provided to the customer. The services provided by the newspaper are daily, weekly or monthly publications but they are funded by a recurring, sticky subscription paid upfront. Basically, very predictable, annuity-like cashflows. Sort of like auto insurance premium renewals. If the company prints cashflows to shareholders as predictably as a bond pays yearly interest to a bondholder, like an annuity or perpetuity or in this case, a growing perpetuity, then the question becomes, how wide are the moats that defend the stability of these bond coupon-like cashflows to shareholders? Well, IBM is a monster in this regard.

IBM has become a service company giant. Even if the technology landscape changes, they will most likely be able to consult and service and advise clients on how to implement these new technologies, no matter how disruptive. Like a Bain or McKinsey can advise enterprises on businesses regarding strategy and operations, IBM is like those guys on steroids and probably more value-adding especially if technology is a critical, yet dynamically changing part of the well-being of today's companies and individuals.

Here's a description in 2001 of how IBM's business had changed even by that point:

By 2001, IT services had become the single largest source of revenue for IBM, generating over 40% of IBM's $86 billion in sales:

Going back to Buffett's preference for recurring, annuity-like cashflows, look at how big the "Recurring Core Franchises" part of IBM's revenues are today, denoted in darker blue:

If you look at the breakdown of revenues for 2014, you'll see Services at 40% and Software at 50%. Okay, I talked about Services revenues before, but what's revenue from Software?

IBM - segment mix

But if you dig deeper into Software, you'll find something interesting. 70% of it is "Software Annuity content".

IBM - revenue growth

So how would you value the following annuity?

Say FCF is the "coupon" for this perpetual bond, so roughly $16 billion per year. Say you divide it by a 10% discount rate to get to the present value of this perpetual annuity. That's $160 billion. The current market cap is $159 billion. 10% may be considered too low, but if the moat is wide enough, maybe it's not.

Now, if there's any element of growth, such that it's a growing perpetuity, then you're dividing by an even lower discount rate. If you divide $16 billion by 9.0%, to account for 1% growth, you're at $178 billion. If you get 3% growth, roughly around the expected GDP rate for the U.S., then you can discount it at 7% to arrive at $229 billion. Different assumptions can be thrown around, but that's the general gist of how Buffett values companies.

To elaborate on this way of looking at cash flows to shareholders, for Buffett, to invest in a company, "the predictability of a company's future cash flow should take on a "coupon-like" certainty like that found in bonds". [1] He then uses a discount rate that ignores the concept of equity risk premium because equity risk premium reflects volatility in the price of a stock, not necessarily the predictability of earnings. Instead, the more certainty there is to the stability of the company's earnings and cash flows, the closer to the risk-free rate (normalized) his discount rate will be. So the question becomes, do IBM's recurring cash flows exhibit this characteristic? Yes.

[1] Robert G. Hagstrom, The Warren Buffett Way (Hoboken, New Jersey: John Wiley & Sons, Inc., 2014), p. 65-66.